___________________________________________________________

The Global Financial Crisis and

the Future of Financial Regulation

in Hong Kong ____________________________________________________________

AIIFL Working Paper No. 4

February 2009

Asian Institute of International Financial Law Faculty of Law

The University of Hong Kong www.AIIFL.com

© February 2009 the authors. All rights reserved. Short text extracts may be quoted without explicit permission provided that full credit including the “©” notice is given to the source.

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The Global Financial Crisis and the Future of Financial Regulation in Hong Kong

Douglas W. Arner ∗

Berry F.C. Hsu ∗∗

Antonio M. Da Roza ∗∗∗

Francisco A. Da Roza ∗∗∗∗

Syren Johnstone ∗∗∗∗∗

Paul Lejot ∗∗∗∗∗∗

∗ Director, Asian Institute of International Financial Law; Director, LLM (Corporate & Financial Law) Programme; and Associate Professor, Faculty of Law, University of Hong Kong. ∗∗ Professor, Department of Real Estate & Construction & Deputy Director, Asian Institute of International Financial Law, University of Hong Kong. ∗∗∗ Research Fellow, Asian Institute of International Financial Law & Centre for Comparative and Public Law, Faculty of Law, University of Hong Kong; and Barrister­at­law. ∗∗∗∗ Former Deputy General Manager of Den norske Bank AS, Hong Kong (subsequently acquired by Unibank A/S); previously approved by the Hong Kong Monetary Authority to act as Alternate Chief Executive of an Authorised Institution and previously licensed by the Securities and Futures Commission as Financial Adviser. ∗∗∗∗∗ Visiting Fellow, Asian Institute of International Financial Law, Faculty of Law, University of Hong Kong. ∗∗∗∗∗∗ Visiting Fellow, Asian Institute of International Financial Law, Faculty of Law, University of Hong Kong; Visiting Research Fellow, ICMA Centre, University of Reading.

The authors would like to thank Hilfred Ho for research assistance, as well as participants in seminars in Düsseldorf, Freiburg, Hong Kong, Kuala Lumpur, Shanghai, Washington DC and Zurich. All errors and opinions unless otherwise noted are those of the authors. This research has been supported by the Hong Kong Research Grants Council General Research Fund grant number HKU 7401/05H.

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Executive Summary

In this study, conducted as part of the University of Hong Kong Law, Policy and

Development Strategic Research Theme, a team from HKU’s Asian Institute of International

Financial Law (AIIFL) investigate the implications of the global financial crisis for the future

of financial regulation in Hong Kong.

The study begins with a discussion of Hong Kong’s financial regulatory system, focusing on

potential weaknesses known to exist prior to the onset of the systemic phase of the financial

crisis in Autumn 2008, in particular, the relationship between the Hong Kong Monetary

Authority (HKMA) and the Securities and Futures Commission (SFC) in respect of the

securities activities of banks, and the SFC and Hong Kong Exchanges and Clearing Limited

(HKEx) in respect of listed company matters. From this basis, the authors present an

overview of the crisis and discuss the specific issues which have arisen in Hong Kong,

highlighting problems relating to American International Group (AIG), a bank run on Hong

Kong’s fifth largest bank (Bank of East Asia) and investment losses at CITIC Pacific, the

Hong Kong subsidiary of a major Mainland Chinese company, along with related responses,

and focusing on complex structured financial products called “Minibonds” arranged by the

now bankrupt Lehman Brothers and sold to retail investors in Hong Kong. Consideration is

given to the issues raised by the structure of the Minibonds, their authorisation and their sale

to retail investors in Hong Kong.

Against this background, the study analyses the performance of Hong Kong’s financial

regulatory system in addressing issues arising from the global crisis, particularly in the

context of the issues raised by the Minibonds. Evaluation is considered in respect of the

approval of complex financial products and regulatory supervision of intermediary behaviour.

The recommendations made by the HKMA and SFC in respect of the regulatory regime,

conduct of business, information and disclosure, risk assessment, dispute resolution and

compensation are considered, before turning to accountability. Weaknesses other than those

raised by the Minibonds are then addressed: financial stability; implementation of

international standards; and credit ratings and credit ratings agencies. In this context, the

study presents a series of recommendations for reform in order to address continuing

problems and existing weaknesses. Finally, the study looks beyond the current crisis and

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argues for regulatory changes to both to prevent future crises and also to strengthen Hong

Kong’s competitiveness as an international financial centre.

Overall, the study is based on the premise that a core feature of any regulatory model is the

identification of problems to prevent or mitigate consequential effects before far­reaching

damage takes hold – this preventative aspect is at the heart of the concept of financial

supervision. The Lehman Brothers Minibonds incident is a problem which materialised as a

result of the global financial crisis leading to the insolvency of Lehman Brothers. It thus

seems likely that there may be other nascent product / misselling issues in the market (which

have nothing to do with Lehman Brothers) but which are as yet unidentified. To the extent

the preemptive function of regulation and supervision might not be working properly reflects

a clear gap in the regulatory framework which needs to be considered and resolved in a

balanced way.

The occurrence of the global financial crisis has, rightly, brought a renewed focus on the

adequacy of Hong Kong’s regulatory architecture. However, such an examination cannot be

undertaken meaningfully without also reviewing the performance of the regulators

themselves within the existing architecture. Such a review, if undertaken, may need to be

conducted independently of the regulators themselves and would need to consider the

adequacy of existing regulatory powers, how well the SFC and HKMA have been able to

execute these powers to fulfil their statutory objectives and functions, what hurdles or

obstacles they may have had to deal with, and in what ways their operations, activities,

policies and practices could be improved for future benefit. 1 While it must be recognised that

procuring compliance with sound regulations is not a straightforward matter, such a review is

an important part of the accountability framework within which regulatory bodies must

operate.

In looking forward, the study suggests that in addition to addressing specific weaknesses in

Hong Kong’s regulatory framework which have been brought to light by the global financial

crisis, the crisis also provides an important opportunity for Hong Kong to consider the overall

design of its regulatory system, focusing on the both core objectives of financial regulation

and Hong Kong’s role and competitiveness as an international financial centre. Specifically,

1 Such a review was of course an important aspect of the Davison Report which led to important developments in Hong Kong’s regulatory framework. See infra note 12 and accompanying text.

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the study concludes that Hong Kong should restructure its regulatory framework in order to

decrease gaps and inconsistencies, increase effectiveness of performance of regulatory

objectives and enhance competitiveness by reducing complexities inherent in the existing

structure through the amalgamation of the existing network of regulators into two primary

regulatory agencies, responsible respectively for: (1) monetary and financial stability; and (2)

market integrity. Using the crisis as an impetus for positive and necessary change would

allow the crisis to be made into an opportunity.

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Contents

1. Introduction

2. Hong Kong’s Financial Legal and Regulatory System

2.1. Overview of Hong Kong’s Financial Regulatory System

2.1.1. HKSAR Government

2.1.2. Central banking and banking: HKMA, HKDPB and HKAB

2.1.3. Securities and futures: SFC and HKEx

2.1.4. Insurance: OCI and HKFI

2.1.5. Pensions: MPFA

2.1.6. Cooperation and coordination between the regulators

2.2. Pre­Existing Weaknesses

2.2.1. IMF review

2.2.2. Financial conglomerates and securities activities of banks:

Relationship between the HKMA and SFC

2.2.3. Listed company matters: Relationship between the SFC and HKEx

2.2.4. Other issues

3. The Financial Credit Crisis and its Effects in Hong Kong

3.1. The Global Financial Crisis

3.2. Impact in Hong Kong: Lehman Brothers, AIG, BEA and CITIC Pacific

3.3 The Lehman Brothers Minibonds Incident

3.3.1 The sale of complex securities

3.3.2 Sales to Hong Kong retail buyers

3.3.3 Minibond structure and purpose

3.3.4 Implications of the structure

3.3.5 Documentation and regulatory concessions

3.3.6 Sales practices

3.4. Responses to the Global Financial Crisis

3.4.1. Responding to the Global Financial Crisis in Hong Kong

3.4.2 Implications for international finance and international financial

centres

4. Resolving Current Problems and Addressing Existing Weaknesses

4.1. Evaluating the Performance of Financial Regulation in Hong Kong

4.2. Evaluating Performance in the Context of Lehman Brothers Minibonds

4.2.1 Approvals for issuance of complex products

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4.2.2 Regulatory supervision of intermediary behaviour

4.2.3 Regulatory performance

4.3. Resolving Current Problems and Addressing Existing Weaknesses: Lehman

Brothers Minibonds

4.3.1. The regulatory regime

4.3.2. Conduct of business

4.3.3. Information and disclosure

4.3.4. Risk assessment

4.3.5. Dispute resolution and compensation

4.3.6. Accountability

4.4. Addressing Other Existing Weaknesses

4.4.1. Financial stability

4.4.2. Implementation of international standards

4.4.3. The role of credit ratings and credit rating agencies

5. Looking Forward: Enhancing Hong Kong’s Competitiveness

5.1. Financial Centre Competition and Competitiveness

5.2. Opportunities

5.3. Reforming Regulatory Structure

5.3.1. Options

5.3.2. Recommendations

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1. Introduction

The global financial system experienced its first systemic crisis since the 1930s in autumn

2008, with the failure of major financial institutions in the United States and Europe and the

seizure of global credit markets. Although Hong Kong was not at the epicentre of this crisis,

it has nonetheless been affected. While the global financial system did not collapse, as the

result of a series of significant government interventions, the full extent of the economic

impact of the Global Financial Crisis of 2008 is yet to be determined, and financial and

economic developments are still unfolding. Nonetheless, the causes are now mostly and

generally understood, with major initiatives underway around the world to revive financial

systems and economies. Serious consideration of reform of financial regulation has also been

initiated, with potentially far­reaching consequences for the future of banking and finance. 2

At the same time, however, the crisis provides a unique opportunity for Hong Kong not only

to address weaknesses highlighted by the crisis, but also to formulate policies in respect of its

longer term role and competitiveness in the international financial system and to enhance its

financial regulatory system. 3

In this paper, following this introduction, Section 2 provides an overview of Hong Kong’s

existing financial regulatory framework, including a discussion of areas of potential weakness

recognised prior to the crisis. The third section discusses the global financial crisis and its

impact in Hong Kong, as well as the regulatory responses to date internationally and in Hong

Kong. Section 4 discusses recommendations for reforms in Hong Kong to address

weaknesses highlighted by the crisis, focusing on issues relating to the Lehman Brothers

“Minibonds” incident. Finally, Section 5 looks forward, recommending that the crisis be

taken not only as the catalyst to resolve existing weaknesses but also to strengthen and

enhance Hong Kong’s role and competitiveness as China’s premier international financial

centre.

2 For detailed discussion, see D. Arner, “‘The Global Credit Crisis of 2008: Causes and Consequences”, AIIFL Working Paper no. 3 (Asian Institute of International Financial Law, Jan. 2009); D. Arner, P. Lejot & L. Schou­ Zibell, “The Global Credit Crisis and Securitisation in East Asia”, 3:3 Capital Markets Law Journal 291 (2008). 3 For a concise discussion, see D. Arner, B. Hsu & A. Da Roza, “Cover Story: The Global Credit Crisis: Implications for Financial Regulation in Hong Kong”, Hong Kong Lawyer (Feb. 2009) (English with Chinese translation).

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2. Hong Kong’s Financial Legal and Regulatory System

As with many other financial centres, Hong Kong’s financial regulatory system has

developed gradually and, with some exceptions, largely in response to a range of financial

crises, in particular following the major international financial crises of 1973, 1987 and 1997.

As a result, whilst strong in individual sectors, gaps and overlaps remain a factor in Hong

Kong’s regulatory system, as shown in clear relief by the fallout from the current global

financial crisis. 4

2.1 Overview of Hong Kong’s Financial Regulatory System

Hong Kong has developed a traditional sectoral regulatory structure for its financial system,

based on separate supervisory bodies for each of the three major sectors (banking, securities

and insurance) with an additional regulatory agency for pensions. 5 However, the regulation of

banks differs, being of a more institutional nature – an issue discussed further in section 2.2.2

and section 5 below.

In each of these areas, regulation essentially has three tiers. The top tier is the Government of

the Hong Kong Special Administrative Region (HKSAR) of the People’s Republic of China

(China or PRC): specifically the Financial Secretary, the Secretary for Financial Services and

Treasury and the Financial Services and the Treasury Bureau (FSTB), all under the direction

of the HKSAR Chief Executive. The HKSAR Government, and especially the FSTB, is

generally responsible for strategic and policy decisions for both the entire and individual

sectors of the financial system.

The second tier is comprised of a series of specialist regulatory agencies, with varying

degrees of independence. This second tier is made up of the Hong Kong Monetary Authority

(HKMA – regulating banking and banks), the Securities and Futures Commission (SFC –

regulating the securities and futures markets), the Office of the Commissioner of Insurance

(OCI – regulating insurance business) and the Mandatory Provident Fund Schemes Authority

(MPFA – regulating the pensions industry). Each regulatory agency operates within the

4 For a detailed discussion of Hong Kong’s financial regulatory system, see B. Hsu, D. Arner, M. Tse & S. Johnstone, Financial Markets in Hong Kong: Law and Practice (Oxford University Press 2006). 5 For a discussion of financial regulatory structure, see D. Arner & J. Lin (eds), Financial Regulation – A Guide to Structural Reform (Sweet & Maxwell 2003).

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framework of one or more major statutes and issues rules, regulations and guidance pursuant

to empowering legislation.

The third tier is made up of a variety of self­regulatory organisations (SROs) which are

subject to the regulatory oversight of the relevant primary regulatory agency and with varying

levels of responsibility for their respective markets and the conduct of their members. In the

banking and insurance sectors, the Hong Kong Association of Banks (HKAB) and the Hong

Kong Federation of Insurers (HKFI), respectively, are tasked with consumer­related issues. In

the securities and futures sector, Hong Kong Exchanges and Clearing Limited (HKEx) and its

subsidiaries own, control and operate the stock exchange, futures exchange and related

clearing houses, subject to SFC oversight.

In addition, certain other bodies also play important roles, especially the Financial Reporting

Council (FRC – responsible for accounting and auditing standards for listed companies under

the Financial Reporting Council Ordinance (Cap. 588) 6 ), the Companies Registry

(responsible for the Companies Ordinance (Cap. 32) 7 ), the Hong Kong Deposit Protection

Board (HKDPB – responsible for Hong Kong’s deposit insurance scheme under the Deposit

Protection Scheme Ordinance (Cap. 581)), the Independent Commission Against Corruption

(ICAC) 8 , the Joint Financial Intelligence Unit (JFIU) and the Consumer Council (established

by the Consumer Council Ordinance (Cap. 216) 9 ).

2.1.1 HKSAR Government

The HKSAR Government is not involved in the day­to­day regulation of the financial system.

Under Articles 106 to 113 of the Basic Law of Hong Kong (Basic Law), the Government is

responsible for a range of aspects of public finance and monetary and financial affairs. In this

context, the Financial Secretary is responsible for the monetary system, the Exchange Fund,

public finance, the financial system and the status of Hong Kong as an international financial

6 See www.frc.org.hk. 7 See www.cr.gov.hk. The Companies Ordinance is currently in the midst of a major review and revision exercise under the remit of the FSTB and the Standing Committee on Company Law Reform (SCCLR). See www.cr.gov.hk/en/standing/index.htm; www.fstb.gov.hk/fsb/co_rewrite/eng/home/home.htm. 8 See www.icac.org.hk. 9 See www.consumer.org.hk. Outside of the context of the Securities and Futures Ordinance and the common law, Hong Kong has a very limited system of consumer protection legislation.

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centre. 10 The FSTB is tasked with implementing the policies set by the Financial Secretary in

relation to public finance, the financial system and Hong Kong’s status as an international

financial centre, including ensuring that Hong Kong’s regulatory regime is up­to­date and

meets the needs of investors. 11 As examples, the Government initiated (on the basis of the

Davison Report 12 and the experiences of the Asian financial crisis) Hong Kong’s most far­

reaching regulatory reforms to date: the demutualisation, merger and listing of the various

exchanges in 1999­2000 and the enactment of the Securities and Futures Ordinance (SFO)

which became effective on 1 April 2003. 13 There is an ongoing dialogue between the

Government and the various regulators about the state of regulation and the industry itself.

2.1.2 Central banking and banking: The HKMA, HKAB and HKDPB

In Hong Kong, the legal and institutional framework for banking is largely based on the

Banking Ordinance (Cap. 155), the Exchange Fund Ordinance (Cap. 66), various ordinances

largely derived from British sources (e.g. Companies Ordinance, Bills of Exchange

Ordinance) and the common law. 14 Following the collapse of the Bank of Credit and

Commerce International (BCCI) in 1991 and a series of bank runs in Hong Kong, the Hong

Kong Monetary Authority (HKMA) was established in 1993 through amendments to the

Exchange Fund Ordinance in 1992 to take over the functions of the Government’s Office of

the Exchange Fund and Office of the Commissioner of Banking, and the Deposit Protection

Scheme Board and Deposit Protection Scheme were established in 2006.

The HKMA 15 has two key functions, as a de facto central bank responsible for the

management of the Exchange Fund, and as a regulator of the banking industry. This legal

framework is complicated by the division of authority between the HKMA and the HKAB

10 HKSAR Chief Executive, Responsibilities of the Financial Secretary and the Secretary for Financial Services and the Treasury (27 Jun. 2003); Financial Secretary, Policy Objectives in Financial Affairs and Public Finance (27 Jun. 2003). 11 See www.fstb.gov.hk. 12 Securities Review Committee, The Operation and Regulation of the Hong Kong Securities Industry: Report of the Securities Review Committee (Hong Kong Government 1988) (“Davison Report”). 13 See HKSAR Government, A Policy Paper on Securities and Futures Market Reform (HKSAR Government, Mar. 1999). 14 For detailed discussion, see Hsu, Arner, Tse & Johnstone, supra note 4, ch. 2. 15 Legally, the “Monetary Authority” (MA) is an individual appointed by the Financial Secretary under the Exchange Fund Ord., s. 5A. The powers under the Banking Ord. are personally vested in the MA. In practice, the MA heads an office known as the HKMA of which he is Chief Executive. See generally www.hkma.gov.hk.

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under the Banking Ordinance and The Hong Kong Association of Banks Ordinance (Cap.

364) (HKAB Ordinance).

2.1.2.1 Exchange fund management

Under the Exchange Fund Ordinance the HKMA is responsible for administering the official

monetary policy, for ensuring the stability of the Hong Kong dollar, and for managing the

Exchange Fund. The HKMA manages the Exchange Fund under powers delegated by the

Financial Secretary in accordance with the Exchange Fund Ordinance. 16 In this respect, the

HKMA’s main obligations are to keep the Hong Kong dollar stable and to manage the

Exchange Fund in a sound and effective manner.

The Exchange Fund 17 forms the basis of Hong Kong’s linked exchange rate mechanism. The

Exchange Fund is to be used, inter alia, “for such purposes as the Financial Secretary thinks

fit affecting, either directly or indirectly, the exchange value of the currency of Hong Kong

and for other purposes incidental thereto.” 18 An additional purpose was added in 1992: the

Financial Secretary is entitled to use the Fund as he thinks fit to “maintain the stability and

integrity of the monetary and financial systems of Hong Kong” and to “maintain Hong Kong

as an international financial centre”. 19 Subject to certain limitations, the Financial Secretary is

empowered to transfer money from the Exchange Fund into the general revenue. 20 Finally,

the Exchange Fund is responsible for all related and other ancillary costs and expenditures of

the HKMA. 21

2.1.2.2 Banking regulation

In its regulatory role under the Banking Ordinance, “the principal function of the HKMA

shall be to promote the general stability and effective working of the banking system”. 22

More precisely, the HKMA “shall take all reasonable steps to ensure that the principal places

of business … of all Authorised Institutions … are operated in a responsible, honest and

16 See HKSAR Chief Executive, supra note 10. 17 The Exchange Fund was created by the Currency Ord. of 1935, later renamed as the Exchange Fund Ord. 18 Exchange Fund Ord., s. 3(1). 19 Exchange Fund Ord., s. 3(1A). 20 Exchange Fund Ord., s. 8. 21 Exchange Fund Ord., s. 6; see also s. 5B. 22 Banking Ord., s. 7(1).

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business­like manner”. 23 “Authorised Institutions” (AIs) are banks, restricted licence banks

(RLBs) and deposit­taking companies (DTCs), the latter two having narrower business

streams. The principal duties and responsibilities of the HKMA as banking regulator are to:

(1) promote the safety of Hong Kong’s banking system; and (2) develop Hong Kong’s

financial infrastructure to enable money to flow smoothly, freely and without obstruction. 24

Importantly, the HKMA is responsible for banking business, defined to include only deposit­

taking and cheque­related services. As a result, all forms of lending business etc. are not

addressed by the Banking Ordinance but rather by the common law and a range of specific

ordinances, especially the Money Lenders Ordinance (Cap. 163), and the rules of the HKAB.

At the same time, however, the HKMA regulates all activities of AIs under the framework of

consolidated supervision.

2.1.2.3 Hong Kong Association of Banks (HKAB)

The HKAB is an organisation whose origin arose out of the Exchange Banks Association

(EBA), which was founded in 1897 as the body representing banks in Hong Kong. 25

Specifically, the HKAB was formed in 1981 under the HKAB Ordinance. Under the HKAB

Ordinance, the objectives of the HKAB include: (1) furthering the interests of licensed banks;

(2) making rules for the conduct of the business of banking; (3) consideration, investigation

and inquiry into all matters and questions connected with or relating to the business of

banking; and (4) representation of its members. 26

Under its rule making powers, most importantly, the HKAB issues the Code of Banking

Practice 27 jointly with the DTC Association and with the endorsement of the HKMA. The

Code establishes standards, enforceable by the HKAB, for consumer­related aspects of

banking business, including terms and conditions, fees, use of customer information,

marketing, handling of consumer complaints and loan recovery.

23 Banking Ord., s. 7(2)(b). 24 Banking Ord., s 7. 25 See www.hkab.org.hk. 26 HKAB Ord., s. 4. 27 Available at http://www.hkab.org.hk/PDF/rules_guidelines/code_e_2008.doc.

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2.1.2.4 Hong Kong Deposit Protection Board (HKDPB)

Following bank runs in Hong Kong after the failure of BCCI and during the Asian financial

crisis and recommendations from both external consultants and a comprehensive review of

Hong Kong financial system in 2003 (discussed further below), the HKDPB and the Hong

Kong Deposit Protection Scheme (DPS) were both established under the Deposit Protection

Schemes Ordinance in 2004, with the DPS commencing operations in 2006. Under the DPS,

in which all licensed banks are required to participate, deposit insurance of up to

HK$100,000 (in HK$ or foreign currency equivalent) per depositor per member is provided

with funding through membership contributions.

2.1.3 Securities and futures: SFC and HKEx

Prior to 1987, capital market regulation in Hong Kong was minimal, with the various

exchanges operating largely on the basis of self­regulation in the context of the common law

framework. While a Securities Commission, a Commodities Trading Commission and a

Stock Exchange Compensation Fund had been created and numerous ordinances enacted to

address securities regulation during the 1970s, 28 the failure of the market in October 1987

exposed the inadequacies of the then­existing system. 29 As a result of that crisis, the

Government commissioned the Securities Review Committee to develop a plan to upgrade

Hong Kong’s securities market infrastructure to international standards in November 1987.

This report, known as the “Davison Report”, served as a blueprint for the modernisation of

capital market regulation in Hong Kong throughout the late 1980s and the 1990s. 30

During the last two decades, Hong Kong’s securities and futures markets have gone through a

profound transformation from a largely domestic market to an international market with

active trading in equity and derivative products. 31 One fundamental aspect of this

transformation has been the establishment of Hong Kong as the preferred market for

mainland Chinese enterprises to raise capital.

28 e.g., Securities Ord. (Cap. 333) (1974); Protection of Investors Ord. (Cap. 335) (1974); Stock Exchange Unification Ord. (Cap. 361) (1980). 29 See generally Davison Report, supra note 12. 30 See Hsu, Arner, Tse & Johnstone, supra note 4, ch. 1. 31 See id.

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2.1.3.1 Securities and Futures Commission (SFC)

The SFC was established on 1 May 1989 under the Securities and Futures Commission

Ordinance 32 (now consolidated into the SFO), pursuant to a recommendation by the

Securities Review Committee. 33 Under the SFO, the SFC is the regulator of the securities and

futures industry in Hong Kong. 34 As stated in the SFO, the objectives of the SFC are to: (1)

maintain and promote the fairness, efficiency, competitiveness, transparency and orderliness

of the industry; (2) promote understanding by the public of the operation and functioning of

the industry; (3) provide protection to the investing public; (4) minimise crime and

misconduct in the industry; (5) reduce systemic risks in the industry; and (6) assist the

Financial Secretary in maintaining the financial stability of Hong Kong by taking appropriate

steps in relation to the industry. 35 In addition, the SFC has general duties to help maintain

Hong Kong’s position as an international financial centre, to facilitate innovation in financial

products, to avoid restrictions on competition, to act in a transparent manner and to use its

resources efficiently. 36

More specifically, the SFC performs two key functions in regulating the securities and futures

markets: as a gatekeeper in respect of entry requirements for intermediaries wishing to

participate in the securities and futures industry; and as a prudential regulator of those who do

so participate. It is a basic requirement of the SFO that any person engaging in one or more of

the nine types of activities regulated by the SFO 37 must be licensed by the SFC in respect of

the activities undertaken, unless it is exempt. Engaging in regulated activities without an

appropriate licence (and not being exempt) is an offence under the SFO. Once a corporation

has obtained a licence, it is prudentially supervised by the SFC in the context of both

applicable legal requirements (primarily the SFO and its subsidiary legislation but also

certain parts of the Companies Ordinance, in particular the prospectus provisions therein) and

regulatory codes of practice and guidelines issued by the SFC which are not law but which

nevertheless require compliance as a condition to retaining licensed status. Banks engaging in

32 Cap. 24 (now repealed). 33 See www.sfc.hk. 34 SFO, s. 5(1). 35 SFO, s. 4. 36 SFO, s. 6. 37 The nine types of regulated activity/licence are: Type 1 – dealing in securities; Type 2 – dealing in futures contracts; Type 3 – leveraged foreign exchange trading; Type 4 – advising on securities; Type 5 – advising on futures contracts; Type 6 – advising on corporate finance; Type 7 – providing automated trading services; Type 8 – securities margin financing; Type 9 – asset management.

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regulated activities are in certain respects handled differently and this is discussed further

below.

2.1.3.2 Hong Kong Exchanges and Clearing Limited (HKEx)

HKEx is the holding company of The Stock Exchange of Hong Kong Limited (SEHK) and

the Hong Kong Futures Exchange Limited (HKFE). 38 HKEx is listed on the Main Board of

the SEHK.

Each of these three entities are contemplated by the SFO as having specific roles in the

structure of Hong Kong’s securities and futures markets. The SEHK and the HKFE are

recognised as exchange companies which may operate stock and futures markets,

respectively. 39 HKEx is recognised as the exchange controller 40 responsible for ensuring an

orderly and fair market in securities and futures contracts traded on or through the SEHK and

HKFE.

In addition, the SFO contemplates the function of the three recognised clearing houses

operated in connection with these markets. 41 The Hong Kong Securities Clearing Company

Limited (HKSCC), a subsidiary of HKEx, clears and settles, through the Central Clearing and

Settlement System (CCASS), all securities transactions effected via the facilities of the

SEHK, other than traded options which are cleared through the SEHK Options and Clearing

House Limited (SEOCH), another SEHK subsidiary. Clearing of futures transactions entered

into on the HKFE is undertaken by the HKFE Clearing Corporation Limited (HKCC), a

subsidiary of the HKFE.

HKEx, the exchanges and the clearing houses are each required to ensure that risks are

managed prudently, to act in the interests of the public, having particular regard to the

interests of the investing public, and to ensure that where such interests conflict with any

other interests, the former should prevail.

38 See www.hkex.com.hk. 39 SFO, s. 19. 40 SFO, s. 59. 41 SFO, s. 37.

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Except in relation to the management of business risk, and the enforcement of their own

listing, trading, clearing and settlement rules, HKEx, the exchanges and the clearing houses

are not responsible for front­line prudential and conduct regulation of market participants,

these functions being performed by the SFC.

The SFC supervises and monitors the activities of HKEx, the exchange companies and the

clearing houses, approves their rules (such as the Listing Rules made by the SEHK) and

amendments to the rules, approves fees charged by them, and administers and enforces the

relevant applicable legislation. It also carries out regular reviews of these activities.

2.1.4 Insurance: OCI and HKFI

The legal and regulatory framework for the insurance market in Hong Kong comprises the

Insurance Companies Ordinance (ICO), a statutory body called the Office of the

Commissioner of Insurance (OCI) headed by the Insurance Authority and self­regulatory

measures. These are supplemented by a large body of common law.

2.1.4.1 Office of the Commissioner of Insurance (OCI)

The OCI was established in 1992 and is the regulatory authority responsible for the insurance

industry in Hong Kong. 42 The OCI is headed by the Commissioner of Insurance who has

been appointed as the Insurance Authority for administering the Insurance Companies

Ordinance (Cap. 41). Under the Insurance Companies Ordinance, the Insurance Authority has

five major functions, namely: (1) authorisation of insurers to carry on insurance business in

or from Hong Kong; (2) regulation of insurers to ensure the financial soundness and integrity

of the insurance market; (3) regulation of insurance intermediaries to ensure an insurance

agent is properly appointed by an insurer and registered with the Insurance Agents

Registration Board (IARB) in accordance with the Code of Practice for the Administration of

Insurance Agents; (4) liaison with the insurance industry in promoting self­regulation by the

industry with the aim of enhancing the protection of policy holders; and (5) reviewing

42 See www.info.gov.hk/oci.

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regularly the guidelines and regulations developed within the system to ensure that they are

keeping with market developments and provide adequate protection to the insuring public. 43

While the OCI is responsible for regulation of insurance companies and intermediaries

(unlike the securities activities of banks), securities activities of such firms and persons

generally fall within the remit of the SFC. 44

2.1.4.2 Insurance Claims Complaints Bureau

The Insurance Companies Ordinance does not provide the OCI with statutory power to

intervene in case of a dispute between policy holders and insurers or insurance

intermediaries. Instead, the industry has a self­regulatory system responsible for the

resolution of disputes. Under this system, the Insurance Claims Complaints Bureau

(established in 1990) handles disputes involving personal claims against insurers on behalf of

policy holders. 45

2.1.4.3 Hong Kong Federation of Insurers (HKFI)

In addition to the OCI, the Hong Kong Federation of Insurers (established in 1988) plays a

key self­regulatory role in respect of insurance business in Hong Kong, 46 similar in many

ways to that of the HKAB in relation to banking. Of most significance, it is responsible for

the Code of Conduct for Insurers, 47 initially adopted in May 1999, which provides standards

of insurance conduct enforceable by the HKFI against its membership.

2.1.5 Pensions: The MPFA

Responsibility for pension regulation is vested with the Mandatory Provident Fund Schemes

Authority (MPFA) 48 which is responsible for the Mandatory Provident Fund Schemes

Ordinance and the Occupational Retirement Schemes Ordinance (ORSO). The MPFA was

established in September 1998 to regulate and monitor the operation of privately managed

43 Insurance Companies Ord., s. 4A. 44 See SFC­OCI MoU, infra note 56. 45 See www.iccb.org.hk. 46 See www.hkfi.org.hk. 47 Available at http://www.hkfi.org.hk/en_tips_customer_conduct.htm. 48 See www.mpfa.org.hk.

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provident fund schemes as part of Hong Kong’s establishment of the Mandatory Provident

Fund (MPF) system of mandatory retirement savings. Its responsibilities as laid down in the

Mandatory Provident Fund Schemes Ordinance include: (1) ensuring compliance with the

Ordinance; (2) registering provident fund schemes and approving qualified persons as

approved trustees of registered schemes; (3) regulating the affairs and activities of approved

trustees and ensuring that they administer the registered schemes in a prudent manner; (4)

making rules or guidelines for the payment of mandatory contributions and for the

administration of registered schemes; and (5) promoting and encouraging the development of

the retirement scheme industry in Hong Kong, including the adoption of a high standard of

conduct and sound prudent business practices by approved trustees and other service

providers.

Since January 2000, the MPFA has also assumed the role of the Registrar of Occupational

Retirement Schemes in administering the ORSO, with responsibility for processing of ORSO

retirement scheme applications, monitoring of ORSO registered schemes, and dealing with

interactions between ORSO and MPF schemes.

Unlike other financial sectors in Hong Kong, to date, there is no third tier SRO in the

pensions sector. At the same time, clearly, there is a significant relationship between MPF

and ORSO business and securities business, leading to some overlap between the functions of

the SFC (as well as the HKMA and the OCI in the areas of banking and insurance) and the

MPFA. To a large extent, these have been addressed through agreements between the various

regulatory authorities in relation to MPF business.

2.1.6 Cooperation and coordination between the regulators

Although all four regulatory agencies independently supervise their respective sectors, their

day­to­day supervisory work cannot be entirely independent, simply because a large number

of the supervised institutions are active in banking, securities, insurance and/or pensions

business.

A Cross­Market Surveillance Committee (CMSC), composed of representatives of the FSTB,

HKMA, SFC, HKEx, OCI and MPFA, was established to exchange market information and

to formulate prompt and appropriate actions where necessary, as well as facilitate supervision

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of financial groups. The CMSC in 2003 was reconstituted into two separate committees, the

Financial Stability Committee and the Council of Financial Regulators. The Council of

Financial Regulators comprises the Financial Secretary (as chair) and representatives from

the HKMA, SFC, OCI, MPFA and FSTB. It is charged with contributing to the efficiency

and supervision of financial institutions, promotion and development of Hong Kong’s

financial markets and the maintenance of financial stability. 49 In turn, The Financial Stability

Committee (FSC) comprises the Secretary for Financial Services and the Treasury (as chair)

and representatives from the HKMA, SFC and OCI. The FSC is charged with monitoring the

functioning of the financial system in Hong Kong, deliberating on issues with possible cross­

market and systemic implications and formulating and coordinating responses, and reporting

to the Financial Secretary as necessary. 50

Further, following a review by the Financial Action Task Force (FATF), 51 Hong Kong

established in April 2008 a new Central Coordinating Committee on Anti­Money Laundering

and Counter Financing of Terrorism (CCC) to supplement the existing Joint Finanical

Intelligence Unit (JFIU) formed in 1989. 52 According to Hong Kong’s response to the FATF

recommended plan of action, 53 the CCC will “steer and coordinate the strategic development

of Hong Kong’s AML/CFT regime in line with internationally recognised standards.” 54 The

CCC comprises the most relevant senior officials responsible for all aspects of Hong Kong’s

AML/CFT regime, including the Financial Secretary (as chair), Secretary for Justice,

Secretary for Financial Services and the Treasury, Secretary for Security, Secretary for

Commerce and Economic Development, Commissioner of Police, Commissioner of Customs

and Excise, ICAC Commissioner, the HKMA Chief Executive, SFC Chairman, and the

Commissioner of Insurance. Following the publication of the FATF Report, Hong Kong’s

Financial Services and the Treasury Bureau will assume responsibility for overall

coordination. In addition, the Customs and Excise Department will be given regulatory

oversight of remittance agents and money changers for AML/CFT purposes.

49 Council of Financial Regulators Terms of Reference. 50 Financial Stability Committee Terms of Reference. 51 FATF, Third Mutual Evaluation Report – Anti­Money Laundering and Combating the Financing of Terrorism: Hong Kong, China (Jul. 2008). 52 See www.jfiu.gov.hk. 53 Id., p. 229. 54 Id.

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In addition to the FSC, Council of Financial Regulators and CCC, the various agencies and

SROs have entered into a series of Memoranda of Understanding (MoUs), which set out the

operational framework for cooperation, further delineate roles and responsibilities and set out

lines of communication and coordination.

The HKMA and the SFC work especially closely in certain respects of their regulatory

functions and since 1995 55 have entered into several mutual MoUs, which set out the

operational details relating to the respective roles and responsibilities of the two regulators

regarding the securities related activities of banking institutions 56 and other matters such as

clearing and settlement systems. 57 The HKMA has further entered into an MoU with the OCI

in 2003 to strengthen cooperation in respect of supervision of entities or financial groups in

which both supervisors have a regulatory interest. 58 The HKMA has also entered into MoUs

with the HKDPB 59 and the FRC, 60 as well as an exchange of letters relating to monetary and

financial affairs with the Financial Secretary. 61 In addition to its MoU with the HKMA, the

HKDPB has also entered into joint MoU with the SFC and the Investor Compensation

Company (ICC – responsible for the securities investor compensation scheme under the

SFO 62 ). 63

In addition to its MoUs with the HKMA and HKDPB / ICC, the SFC has also entered into

MoUs with the Insurance Authority, 64 MPFA, 65 FRC 66 and a series of MoUs with HKEx and

its subsidiaries. 67

55 HKMA & SFC, Memorandum of Understanding on Cooperation in respect of Supervision of Entities in Financial Groups (23 Oct. 1995). 56 SFC & HKMA, Memorandum of Understanding between the Securities and Futures Commission and the Hong Kong Monetary Authority (12 Dec. 2002) (“SFC­HKMA MoU”). 57 SFC & HKMA, Memorandum of Understanding between the Securities and Futures Commission and the Hong Kong Monetary Authority (4 Nov. 2005) (concerning the new oversight regime under the Clearing and Settlement Systems Ordinance). 58 HKMA & OCI, Memorandum of Understanding between the Monetary Authority and the Insurance Authority (19 Sep. 2003). 59 See www.info.gov.hk/hkma/eng/bank/index.htm; http://www.dps.org.hk/en/cooperation_hkma.html. 60 HKMA & FRC, Memorandum of Understanding between Hong Kong Monetary Authority and Financial Reporting Council (19 Nov. 2007). 61 Financial Secretary, Letter from the Financial Secretary to the Monetary Authority, Functions and Responsibilities in Monetary and Financial Affairs and Monetary Policy Objective (25 Jun. 2003). 62 Recognised as an investor compensation company under SFO, s. 79. 63 HKDPB, SFC & ICC, Memorandum of Understanding between the Hong Kong Deposit Protection Board, Securities and Futures Commission and Investor Compensation Company Limited (8 Jul. 2008). 64 SFC & Insurance Authority, Memorandum of Understanding between Securities and Futures Commission and Insurance Authority (20 Dec. 2005). 65 SFC & MPFA, Memorandum of Understanding concerning the Regulation of Mandatory Provident Fund Products (23 Apr. 2003) (replacing an earlier MoU from Jun. 1999).

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The OCI (through the Insurance Authority) has also been active in this respect, with MoUs

with the MPFA 68 and the FRC, 69 in addition to the MoUs with the SFC and HKMA noted

above.

In relation to MPF issues, the HKMA, SFC, OCI and MPFA have entered into a four­party

MoU addressing regulatory aspects of the various MPF intermediaries (which include banks,

securities firms and insurance companies). 70

In addition to the above, the Financial Reporting Council has entered into additional MoUs

with the SEHK 71 and with the Hong Kong Institute of Certified Public Accountants

(HKICPA). 72

Overall, one can say that the structure of Hong Kong’s regulatory system is not easy for the

uninitiated nor even for financial institutions and the various regulatory bodies themselves to

understand. The presence of so many MoUs addressing the relationships between regulatory

bodies is to some extent a testimony to the gaps and overlaps in the roles of each of the

regulators and/or that their roles are inadequately delineated in relation to the financial

marketplace as a whole. The present arrangements have resulted in layers of complexity

beyond the statutorily defined architecture and this contributes to a lack of clarity and

certainty among both regulators and the financial intermediaries they regulate. More needs to

66 SFC & FRC, Memorandum of Understanding between the Securities and Futures Commission and the Financial Reporting Council (12 Nov. 2007). 67 SFC & HKEx, Memorandum of Understanding on matters relating to: SFC Oversight, Supervision of Exchange Participants, Market Surveillance (20 Feb. 2001); SFC, HKEx & SEHK, Memorandum of Understanding for the Listing of Hong Kong Exchanges and Clearing Limited on the Stock Exchange of Hong Kong between Securities and Futures Commission, Hong Kong Exchanges and Clearing Limited and the Stock Exchange of Hong Kong (22 Aug. 2001); SFC & SEHK, Memorandum of Understanding Governing Listing Matters (28 Jan. 2003); SFC & HKEx, Agreed Interpretation of Terms in the MoU [22 Aug. 2001] for the Purposes of the Commencement of the SFO (11 Apr. 2003). SFC / HKEx MoUs are discussed further below. 68 MPFA & Insurance Authority, Memorandum of Understanding between the Mandatory Provident Fund Schemes Authority and the Insurance Authority (20 Apr. 2004). 69 Insurance Authority & FRC, Memorandum of Understanding between the Insurance Authority and the Financial Reporting Council (19 Dec. 2007). 70 Monetary Authority, Insurance Authority, SFC & MPFA, Memorandum of Understanding concerning the Regulation of MPF Intermediaries (1 Jan. 2004) (replacing an earlier MoU from Oct. 1999). 71 SEHK & FRC, Memorandum of Understanding between the Stock Exchange of Hong Kong and the Financial Reporting Council (27 Dec. 2007). 72 HKICPA & FRC, Memorandum of Understanding between the Hong Kong Institute of Certified Public Accountants and the Financial Reporting Council (20 Feb. 2008).

22

be done at the statutory level to create a clear and well defined regulatory architecture for the

regulation of financial services, intermediaries and markets.

2.2 Pre­Existing Weaknesses

As can be seen from this short introduction, for a jurisdiction of 7 million people, Hong Kong

has a complicated system of financial regulation. As discussed previously, this is partly the

result of the way the in which the system has developed. In some cases, these complexities

stem from responses to previous crises and in other from the need to manage the

requirements of: (1) local consumers and businesses; (2) Hong Kong’s role as an

international financial centre; (3) Hong Kong’s traditional role as an international trading port

and entrepôt; and (4) starting from the late 1970s, Hong Kong’s role as the gateway to

mainland China. 73

At the same time, even before the current financial crisis, a number of weaknesses in Hong

Kong’s financial system had been identified in the context of relationships between regulators

and activities of a cross­sectoral nature, repeatedly revealing structural problems.

2.2.1 IMF review

In 2003, the International Monetary Fund (IMF) conducted a thorough review of Hong

Kong’s financial regulatory system. 74 This Financial System Stability Assessment is part of

the Financial Sector Assessment Programme (FSAP), a joint IMF/World Bank effort created

following the Asian Financial Crisis and directed at improving the soundness of financial

systems in member countries. 75 The IMF concluded that Hong Kong largely has an

appropriate legal and regulatory framework for financial stability, though with some

weaknesses, particularly in relation to accounting practices, financial conglomerates, the

relationship between the SFC and HKEx, and independence of regulatory agencies.

73 For a full discussion, see Hsu, Arner, Tse & Johnstone, supra note 4. 74 IMF, People’s Republic of China Hong Kong Special Administrative Region: Financial Stability Assessment (Jun. 2003). 75 For a detailed discussion, see D. Arner, Financial Stability, Economic Growth and the Role of Law (Cambridge University Press 2007), ch. 2.

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The global financial crisis has brought into clearer focus certain of these issues, as well as

others which were not raised by the IMF. Of these issues, the two most significant are the

relationship between the HKMA and SFC in relation to the securities activities of banks, and

the relationship between the SFC, HKEx and the Listing Rules.

2.2.2 Financial conglomerates and securities activities of banks: Relationship between

the HKMA and SFC

As noted above, although Hong Kong has a primarily sectoral regulatory framework, an

important qualification to this structure concerns the activities of banks. While in the context

of insurance and pensions activities, the HKMA retains primary authority, in the context of

securities activities of AIs (i.e., banks) the role is divided between the SFC as the lead

regulator for the securities industry and the HKMA as the main supervisor of banks

undertaking securities business. This anomaly has been one of the central points of focus in

considering the problems surrounding the sale of Lehman Brothers Minibonds to retail

investors in Hong Kong.

Persons engaging in activities regulated by the SFO must be licensed (unless exempt) and are

subsequently prudentially regulated and supervised However, AIs and their staff engaging in

such activities are handled differently from non­bank corporations and their staff. First, the

means of licensing is different. An AI must instead be registered with the SFC as a

“registered institution” (RI) before conducting regulated activities (except for leveraged

foreign exchange trading (Type 3) and securities margin financing (Type 8) activities for

which exemptions are available for AIs). 76 While an AI must lodge an application for

registration with the SFC, the SFC will refer it to the HKMA for consideration. The HKMA

will advise on whether the AI is fit and proper for registration under the SFO criteria. Based

on the HKMA’s advice, the SFC decides whether to approve the application – if approved,

the AI will become an RI for the purposes of the SFO and the SFC. Any person who carries

on a regulated function on behalf of an RI must register his name and details with the HKMA

and must be and remain fit and proper, again under the SFO criteria. Second, the means of

supervision are different. Under the Banking Ordinance, the HKMA undertakes consolidated

supervision over all activities of AIs and is thus responsible for the day­to­day supervision of

76 In accordance with SFO, s. 119(1), AIs must apply to the SFC for registration to carry out one or more of the regulated activities.

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all securities and futures activities of RIs. Nonetheless, the securities and futures activities of

RIs are to be regulated and supervised to similar regulatory standards as those applying to

non­bank corporations, i.e. RIs are subject to the same SFC codes of practice as are non­bank

licensed corporations 77 (an important exception being the Securities and Futures (Financial

Resources) Rules as RIs are instead subject to the HKMA’s Capital Adequacy Rules).

Given that the HKMA is the day­to­day supervisor of RIs, the SFC must consult the HKMA

before implementing new regulations. In turn, the HKMA may consult the SFC in the

interpretation of rules and guidelines. This is intended to ensure consistent interpretation and

approach given that the SFC is the ultimate authority in relation to the regulatory process

regarding the securities and futures industry.

Regarding the specific means by which the activities of RIs are prudentially regulated, the

SFO provides that the SFC may “in performing any of its functions in relation to [any RI]

rely, in whole or in part, on the supervision of such [RI] by the Monetary Authority”. 78 The

arrangements by which the HKMA and SFC are to coordinate their respective roles and

responsibilities in relation to the securities and futures activities of RIs are set out in an

MoU, 79 the stated overall goal of which is close cooperation and consistent regulation of all

intermediaries irrespective of whether they are supervised by the SFC or the HKMA. With

this goal in mind, the MoU seeks to eliminate gaps and overlapping of roles and

responsibilities of the two regulators in relation to regulating the securities business of

banking institutions, and to enhance the exchange of information. More specifically, it details

the requirements applicable to RIs and establishes the division of work between the SFC and

the HKMA especially with regard to the supervisory process and investigations. According to

the MoU the HKMA “is the frontline supervisor of [RIs] responsible for the day­to­day

supervision of the carrying on of regulated activities by [RIs]” and that it must perform on­

site inspections of RIs “in a manner comparable to that adopted by the SFC in relation to

[non­bank] licensed corporations”. 80 Where the HKMA conducts an investigation of an RI it

77 Until the introduction of the SFO, certain AIs were allowed to act as “exempt dealers” and were not required to observe SFC regulations. 78 SFO, s. 5(3). 79 SFC­HKMA MoU, supra note 56. The MoU replaced an earlier version from 1995 (see supra note 56) to take account of changes to the regulatory framework that occurred with the introduction of the SFO. 80 See id., para. 7.2.

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is required to keep the SFC informed. However, where the SFC is considering to exercise its

investigative powers, 81 it is required to consult with the HKMA before doing so. 82

Not surprisingly, these regulatory arrangements in relation to RIs have resulted in some level

of confusion. The issue is discussed further below.

2.2.3 Listed company matters: Relationship between the SFC and HKEx

As already mentioned, the SEHK is empowered under the SFO to make rules for, inter alia,

applications for the listing of securities and the requirements to be met before securities may

be listed. 83 The Listing Rules have been made under such provisions and the SEHK is

responsible for administering them.

2.2.3.1 The dual filing system

The Listing Rules operate on a contractual basis between the SEHK and the issuer and its

related parties. They are not themselves laws and so do not have the force of law. However,

the Listing Rules do enjoy a measure of statutory backing by virtue of the Securities and

Futures (Stock Market Listing) Rules (SMLR) which is subsidiary legislation under the SFO

made by the SFC. 84 The SMLR require an applicant for listing to comply with the Listing

Rules and is specifically concerned with the quality of information disclosure by listed

companies and listing applicants. Under the SMLR, companies that disseminate information

to the public have to file a copy of the disclosure materials, including prospectuses and listing

documents, with the SFC (the “dual filing” system). 85 Further, the SMLR provides that a

company may simply authorise the SEHK to making the filing on its behalf.

Any person who intentionally or recklessly provides false or misleading information when

making a disclosure commits an offence under the SMLR, 86 and is subject to the statutory

powers of the SFC. The SFC will be able to employ its existing investigatory powers in

gathering evidence and establishing the facts. Specifically, section 384 of the SFO states that

81 Specifically, those under SFO, s. 182. 82 SFC­HKMA MoU, supra note 56, para. 9.2. 83 SFO, s. 23. 84 The SMLR came into effect on 1 Apr. 2003, the same time as the SFO. 85 See SMLR, rules 3 & 5, concerning listing applications and other disclosures to the public. 86 SMLR, s. 384.

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persons who intentionally or recklessly provide false or misleading information in listing

documents and ongoing disclosure materials to specified recipients, including the SFC and

the SEHK, will be liable to prosecution. In appropriate cases, the SFC may prosecute or refer

to the Department of Justice to prosecute offenders. In addition, private individuals (such as

shareholders) may bring an action against such persons in respect of false or misleading

communications under section 391 of the SFO.

In line with the model practised in all major overseas markets, the SFC is able to comment on

the draft listing disclosure materials (principally, the listing document cum prospectus) and

may, within 10 business days, object to a listing application on the basis of insufficient or

inadequate disclosure. 87 The SEHK remains the point of contact with listing applicants and

conducts the front­line review, with arrangements between the SFC and the SEHK to ensure

consistency of comments given to the listing applicant.

The SMLR also empowers the SFC to object to a listing if the applicant does not comply with

the applicable rules and requirements or if it appears that the listing would not be in the

interest of the investing public or in the public interest. 88 The SFC has stated that, in the event

it makes an objection, the applicant would have a full right of appeal to the independent

Securities and Futures Appeal Tribunal for a fresh review. 89

The SMLR also provides for suspension of dealing in a security as directed by the SFC under

certain circumstances. In such cases, there are rights to make representations by the issuer or

the SEHK. 90 Professionals and intermediaries including financial advisers will be able to

make representations on behalf of the issuers.

87 SMLR, cl. 6(2) empowers the SFC to object to a listing if the applicant does not comply with the applicable rules and requirements or if it appears that the listing would not be in the interest of the investing public or in the public interest. The SFC has stated that, in the event it makes an objection, the applicant would have a full right of appeal to the independent Securities and Futures Appeal Tribunal for a fresh review. (This however would require amendments to the list of specified decisions in SFO, sch. 8.) 88 SMLR, Rule 6(2). 89 See supra note 87. 90 SMLR, Rules 8 & 9.

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2.2.3.2 Review of the three­tier structure and dual­filing regime

The three­tier structure (Government­SFC­HKEx/SEHK) relating to listing matters was the

subject of an external review which led to the publication of a report in March 2003. 91 The

stated objective of the review was to “review the roles and functions of the Government, the

[SFC and HKEx] over matters relating to the listing of securities and issuers with listed

securities, the operation of the regulatory structure as regards listing matters and the lines of

communication among the three tiers.” 92

Although the dual filing regime was introduced as a means to improving the effectiveness of

enforcement as regards the disclosures of listed companies by providing for an increased role

for the SFC as regards the quality of disclosures, the Expert Report was critical of the dual

filing regime as: (1) “inherently inefficient and costly” as a result of work duplication; (2) not

dealing adequately with instances of non­disclosure; (3) a complicated delineation of

responsibility between the HKEx and the SFC; and (4) giving rise to the possibility of

exacerbating frictions between the SFC and HKEx. 93

The Report recommended these issues be addressed with two primary changes. First, HKEx

should be relieved of its listing responsibilities which should instead be taken up by a new

entity which the Report calls the “Hong Kong Listing Authority” (HKLA) and which would

operate as part of, or under the auspices of, the SFC. While the Report expresses the hope that

this would improve communication between the SFC and the HKEx, such a consequence is

obviously far from certain. Second, the Listing Rules should receive further statutory backing

than at present under the SMLR in order for a stronger array of statutory sanctions to be

available to deal with instances of non­compliance. However, the Report considered that the

Listing Rules should retain their present non­statutory status so as to preserve flexibility, for

example, to deal with market developments.

91 Report by the Expert Group to Review the Operation of the Securities and Futures Market Regulatory Structure (Mar. 2003). 92 Expert Group Report, p. 1. 93 Id., pp. 13, 45, 55.

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At present, a consultation is underway on proposed amendments to the SMLR. 94 Under this

proposal, a number of Listing Rules would be removed to form part of the SMLR. Such

matters relate to disclosure, namely, as to price sensitive information, annual and periodic

reports, and notifiable and connected transactions. While the proposal would make no

substantive changes to the provisions, the effect of removing them would be that they cease

to be contractual matters between the SEHK and the issuer and its related parties and would

instead become statutory requirements. As such, this proposal has the potential to enhance an

area of weakness in Hong Kong’s regulation of listing and public offerings of securities.

Nonetheless, there remain strong arguments for removing the Listing Rules from the SEHK

to the SFC, as has been done in the United Kingdom in 2000 through the transfer of authority

in this regard from the London Stock Exchange to the Financial Services Authority.

2.2.4 Other issues: Review of banking stability

In July 2008, the HKMA released an external review of its work in the area of banking

stability. 95 Overall, echoing the IMF’s conclusion, the Carse Report concluded: “No

fundamental deficiencies in the regulatory and supervisory framework have been identified.

But a number of enhancements can be made which will provide an even sounder foundation

to cope with the challenges ahead.” 96 In its analysis and in respect to enhancements, the

report focused on six main areas: (1) general trends and issues; (2) governance issues relevant

to banking stability; (3) the Monetary Authority’s functions and powers in the Banking

Ordinance; (4) the supervisory framework; (5) the policy framework; (6) authorisation; and

(7) safety net arrangements. In some areas, the report was prescient: the need to review

deposit protection arrangements 97 and regulatory structure. 98 It is also certainly correct in

stating that “priorities over the next few years will be set to a large extent by the lessons

learned internationally from the sub­prime crisis” and at the same time that “[t]he future

agenda in Hong Kong will also be set by local considerations, including particularly the need

to manage the increasing business integration with the Mainland.” 99

94 SFC, A consultation paper on proposed amendments to the Securities and Futures (Stock Market Listing) Rules (Jan. 2005); FSTB, Consultation paper on proposed amendments to the Securities and Futures Ordinance to give statutory backing to major listing requirements (Jan. 2005). 95 D. Carse, Review of the Hong Kong Monetary Authority’s Work on Banking Stability (Jul. 2008) (“Carse Report”). 96 Id., pp. iv­v. 97 Id., p. 51. 98 Id., p. 15. 99 Id., p. 2.

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At the same time, the Carse Report did not anticipate the scale of problems which would

emerge as the global financial crisis intensified and how these would highlight a range of

particular problems beyond the context of banking stability.

3. The Global Financial Crisis and its Effects in Hong Kong

Although certain problems were known to exist with financial regulation in Hong Kong, the

global financial crisis highlighted certain of these and also brought to light new issues.

3.1 The Global Financial Crisis

In essence, the current global financial crisis resulted from an unprecedented period of

excessive lending and excessive investment incentivised by a series of significant economic

and regulatory factors. 100 Excessive lending most directly arose in residential property

markets in a number of developed countries, especially the market for subprime residential

mortgages in the United States. However, it was prevalent in virtually all asset classes,

including commercial property, corporate lending (particularly for mergers and acquisitions

and private equity transactions), commodity investments and international (especially

emerging markets) equities. These excesses were global, impacting almost every market and

asset class. Generalised excessive borrowing and lending were fuelled by excessive

investment from a wide range of investors around the world.

Excessive lending and investment were inextricably interconnected through a range of

transaction structures derived from securitisation. At its simplest, securitisation allows the

distribution of risks among a pool of investors, in some cases reducing the cost of funds for

borrowers and reducing the risk to individual lenders of defaults on underlying loans.

However, the structure has the potential to provide significant incentives for abuse. In the

United States, new loans came increasingly to be made not by commercial banks with an

ongoing interest in their performance but instead by specialist loan aggregators, that would

seek to profit from the mere arranging and subsequent sale of loans and thus lacking a

continuing interest in the ability of borrowers to service the debts they had initiated. The

100 For a detailed discussion, see sources cited supra note 2.

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severing of traditional links between loan origination and servicing became most noticeable

in the weaker sectors of the residential housing finance market.

Securitisation was the central linkage between excessive investment in credit securities and

excessive borrowing and lending. Excessive investment was largely the result of economic

factors, e.g. low interest rates and imbalances in saving and investment between the Anglo­

American economies and the rest of the world, particularly Japan, China and the major oil­

producing countries.

The technology of securitisation was developed and expanded significantly over the past

decade to encompass a range of ever­more complex techniques, structures and products,

including structured investment vehicles (SIVs) and conduits, collateralised debt obligations

(CDOs), collateralised loan obligations (CLOs), synthetic securitisations and a range of

others such as CDO 2 s and synthetic CDOs. Many of these took the technology of

securitisation (pooling, off­balance sheet, investor funding) and combined it with that of

over­the­counter (OTC) derivatives, especially credit derivatives such as credit default swaps

(CDSs).

In the period leading up to the global credit crisis, such techniques received support and

developmental incentives from regulators around the world, especially through the

internationally developed and globally implemented Basel Capital Accords. 101 This

combination of debt capital market technology, regulatory incentives, low interest rates and

massive global investor demand provided the foundations for development of excessive

leverage throughout the financial system and setting the stage for the eventual crisis.

At the same time, investment banks (lightly regulated) and managed funds, hedge funds (not

regulated), and other funds (some regulated and some not), became increasingly dominant in

the financial markets, taking major proprietary trading positions. These participants made up

what is now known as the “shadow banking” system, outside of mainstream regulatory

supervision.

101 Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards (Jul. 1988) (“1988 Basel Accord”); idem., International Convergence of Capital Measurement and Capital Standards: A Revised Framework – Comprehensive Version (Jun. 2006) (“Basel II”).

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The stage was thus set for an inevitable crash, and which brought about the crisis and the

great unwinding that continues even now, bringing into question of the effectiveness of

financial regulatory systems and financial risk management and corporate governance.

By the end of 2006, residential property prices in the United States and a range of other

Western countries had reached unsustainable levels. As central banks around the world began

to raise interest rates to address potential inflationary concerns resulting from rapid global

economic growth, weaker residential mortgage borrowers in the United States began to have

difficulties meeting their obligations, and defaults on loans began to increase. At the same

time, as new purchasers stopped entering the markets, residential property prices began to

decrease rapidly, triggering a spiral of defaults and foreclosures.

This process, set off by peaks in residential mortgage markets and growing defaults and

foreclosures, was rapidly transmitted through the structures of securitisation throughout the

global financial system. In reality, no one knew who owned the impaired loans, as a result of

their repackaging and re­repackaging into CDOs and so on, sold and traded as securities.

Markets ceased to deal in these instruments which were now of uncertain value. The markets

began to lose confidence in those institutions which had been very active in the securitisation

market, realising that when the transactional flows stopped, these institutions will be left

holding substantial amounts of now illiquid and hard to value papers, derived from and

backed by impaired loans. Institutions such as Northern Rock in the United Kingdom and

Bear Stearns in the United States found themselves unable to fund their continuing operations

in the short­term money markets.

Following the demise of Bear Stearns, market confidence continued to deteriorate, with

financial institutions increasingly wary of dealing with one another, even in the context of

short­term interbank dealings. At the same time, markets began to scrutinise those institutions

viewed as heavily exposed. Whilst there was potential systemic risk, it was the bankruptcy of

Lehman Brothers on 15 September 2008, combined with the (effective) nationalisation of

American International Group (AIG), which finally triggered the crisis.

As a result of the crisis, the governments of the United States, the European Union and

Switzerland, inter alia, were forced to intervene dramatically in order to prevent the systemic

crisis from bringing about a global financial collapse, through measures including interest

32

rate cuts, massive liquidity infusions, capital injections, guarantees and financial asset

purchases. At the same time, these actions, while sufficient to prevent the collapse of the

global and most domestic financial systems (Iceland being the exception), were not sufficient

to prevent major adverse economic consequences, albeit less severe to date than those of the

1930s.

3.2 Impact in Hong Kong: Lehman Brothers, AIG, BEA and CITIC Pacific

As noted at the outset, Hong Kong has not been immune from the impact of the global

financial crisis. Notable effects include a run on Bank of East Asia (BEA), a panic among

local AIG policyholders, fallout from the failure of Lehman Brothers particularly in the

context of structured investment products sold to local retail investors and large foreign

exchange losses of CITIC Pacific. Of these, the most significant have been problems relating

to Lehman Brothers “Minibonds”, discussed in greater detail in section 3.3.

As noted above, on 15 September, Lehman Brothers filed for bankruptcy. While this was one

of the series of events leading to and setting off the global financial crisis, it was also the

triggering off of the highest profile incident with the most damaging impact to Hong Kong

flowing from the global financial crisis. At the same time, the insolvency of the firm caused

far less disruption to the wholesale markets in Hong Kong than in the other major financial

centres of London and New York. At the same time as the failure of Lehman Brothers, the

near failure of AIG triggered a rush by insurance policyholders of its subsidiary AIA(HK) to

redeem their policies. While the US Government’s effective nationalisation of AIG prevented

much more serious consequences in Hong Kong, had AIG actually been allowed to fail (as

was the case with Lehman Brothers), in all likelihood Hong Kong’s financial regulatory

system would have been much more hard pressed to cope.

In addition to the direct impact on the local subsidiaries of Lehman Brothers and AIG, the

resulting market turmoil also impacted Hong Kong. Most significantly, on 24 September,

Hong Kong experienced its first major bank run since the Asian Financial Crisis: thousands

of customers descended on branches of BEA on 23­24 September to demand immediate

withdrawal of their deposits, following the spread of rumours by way of mass circulation of a

spate of mobile telephone text messages that the bank’s financial soundness was in question

as a result of exposures to Lehman Brothers and AIG, and that it might soon be taken over by

33

the HKSAR Government. 102 Following general liquidity provision by the HKMA to calm

markets 103 and public statements from the bank’s chairman, 104 the Financial Secretary, the

Chief Executive of the HKMA 105 and major local business figures, the run was halted without

further incident. Once again, however, what could have been a major incident did not so

develop, once again unlike experiences in other major developed jurisdictions, including the

United States and United Kingdom.

Finally, as a consequence of market turmoil, especially the rapid decline of the Australian

dollar against the US dollar in foreign exchange markets, CITIC Pacific, the Hong Kong­

listed and incorporated subsidiary of the major state­owned Mainland conglomerate CITIC,

disclosed on 20 October that it had lost approximately HK$ 15.5 billion (US$ 2 billion) on

long­dated structured foreign exchange option contracts derivatives popularly known as

“accumulators”. Following the announcement, the SFC has initiated a formal investigation.

3.3 The Lehman Brothers Minibond Incident

The 15 September 2008 bankruptcy filing of Lehman Brothers produced second order effects

on individuals in Hong Kong, leading to widespread popular disquiet and public protests, and

which have lessons for effective financial regulation in Hong Kong. As discussed in further

detail below, both the SFC 106 and the HKMA 107 have produced reports for the Financial

Secretary addressing issues that have arisen out of the incident. However, before turning to

issues arising it is necessary to provide some understanding of the products themselves and

their impact in Hong Kong resulting from Lehman Brothers’ failure. 108

Lehman Brothers was a leading global dealer in credit and interest rate products and

securities. Structuring securities was important in its activities and the firm’s sales to retail

buyers in Asia became prolific, including sales to Hong Kong retail buyers of complex

102 “Hong Kong bank recovers from run”, BBC News, 25 Sep. 2008. 103 HKMA, “HKMA says Hong Kong banking system is sound”, HKMA Press Rel. (24 Sep. 2008). 104 BEA, “Announcement”, BEA Press Rel. (24 Sep. 2008), stating BEA’s respective outstanding exposures to Lehman Brothers and AIG were HK$422.8 million and HK$49.9 million. 105 HKMA, “Interbank Liquidity as at 30­9­2008”, HKMA Press Rel. (30 Sep. 2008). 106 SFC, Issues Raised by the Lehman Minibonds Crisis: Report to the Financial Secretary (Dec. 2008) (“SFC Report”). 107 HKMA, Report of the Hong Kong Monetary Authority on Issues Concerning the Distribution of Structured Products Connected to Lehman Group Companies (Dec. 2008) (“HKMA Report”). 108 For further discussion, see P. Lejot, “Dictum non meum pactum: Lehman’s minibond transactions”, 38 Hong Kong Law Journal 585 (2009).

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structured notes branded “Minibonds”, 109 which were unlisted debt securities arranged by

Lehman Brothers and sold through 21 bank and securities dealer distributors. 110 As is set out

in the SFC’s report, Pacific International Finance Limited (PIFL), a Cayman Islands­

incorporated SPV issuer, 111 issued approximately HK$14 billion of issued structured products

(mainly unlisted credit­linked notes) marketed as “Minibonds” to retail investors in Hong

Kong, via licensed banks and securities brokers and arranged by a Hong Kong subsidiary of

Lehman Brothers Holdings. 112 The Minibonds were linked to the credit of companies

including HSBC, Hutchison Whampoa, DBS, Swire Pacific, Sun Hung Kai Properties,

Goldman Sachs and Morgan Stanley. A total of 32 series of Minibonds have been issued.

When Lehman Brothers filed for bankruptcy three of the 32 series of Minibonds had matured

and one series had been the subject of an early call. In respect of these four series investors

were repaid the principal amount of their investments amounting approximately HK$1.3

billion. There remained Minibonds with a nominal value of HK$12.6 billion in the hands of

approximately 34,000 or more investors (based on the number of security accounts at banks

and licensed corporations holding the Minibonds – there may be duplication if customers

hold Minibonds in more than one account). 113 These structured products were unlisted and

were made up of: (1) the previously described Minibonds totalling approximately HK$13.9

billion; (2) equity­linked notes (ELNs) totalling slightly over HK$70 million: and (3) fund­

linked notes totalling HK$80 million.

The present controversy is over the Minibonds: Lehman Brothers’ collapse triggered

contractual provisions in the Minibond issues requiring unwinding of the underlying financial

structure such that their value immediately fell to no more than a fraction of the amounts

paid.

109 “Retail” means buyers of financial instruments who are not professional investors or intermediaries and whose participation in any single issue is modest. They may be intelligent, clear­sighted and accustomed to buying and selling any such instruments but could not reasonably be seen as sophisticated. 110 Lehman Brothers subsidiaries were licensed by the SFC in corporate finance and securities advisory, and securities and futures dealing. No Lehman Brothers company has held a Hong Kong banking licence. Lehman Brothers did not directly market or sell Minibonds to Hong Kong buyers although members of its staff may have assisted the sales process conducted by distributors. 111 Commonly referred to as an orphan SPV, that is not owned by or legally controlled by the person whose special purpose it has been established – while at the same time, that person should be able to rely upon the fact that, in practice, the SPV will carry out the transaction or transactions into which it is expected to enter in a manner which is predictable. 112 SFC Report, supra note 106, s. 13 (“Impact of failure of Lehman Brothers Holdings Inc. on Hong Kong Investors”); HKMA Report, supra note 107, s. 2 (“Lehman structured products”). 113 SFC Report, supra note 106, paras. 13.3­13.4.

35

This leads to questions that include:

1. The effectiveness of the regulation of the marketing and sale of complex financial

instruments, in particular requirements for transaction information disclosure.

2. The quality of point­of­sale supervision of financial intermediaries that market

securities to individual investors or consumers.

3. Whether sales incentives given to Minibond distributors encouraged misselling of

securities, 114 in particular sales being induced with incomplete or misleading

information. 115

4. Whether the law ensures contractual even­handedness in the sale of proprietary

complex financial instruments to retail and other investors.

3.3.1 The sale of complex securities

Many types of investors use complex transactions, largely as a result of the growing utility of

securitisation, other forms of credit risk transfer, financial derivatives, and a prevailing trend

for investment barriers to be dismantled. They are legitimate instruments but present

problems of completeness of disclosure that market regulators are usually expected to

monitor. This is a problem not only for retail users but for many professional intermediaries,

as recent English case law and the current financial crisis both seem to show. 116 To be

considered fair contracts, complex instruments must:

1. Carry warnings that make clear their speculative nature; and

2. Be supported by information sufficiently complete and well­presented to allow the

decision of a reasonable buyer to be fairly informed. 117

114 Lehman paid its distributors fees of as much as 5 per cent of Minibond sale proceeds. 115 Claims against distributors for misselling could also suggest misrepresentation or fraudulent mistake in contract formation, and infractions arising from failure to meet regulatory compliance requirements, e.g. in ensuring that sales staff are properly acquainted with the terms of complex financial products. The HKMA and SFC indicate that over 95 per cent of complaints together received from Minibond holders allege point of sale misselling by distributors. SFC Report, supra note 106 & later HKMA & SFC notices, available at http://www.info.gov.hk/hkma/eng/press/category_f.htm. 116 A leading banking misrepresentation case Peekay Intermark Limited & Another v Australia and New Zealand Banking Group Ltd [2005] EWHC 830 (Comm), [2006] EWCA Civ 386 showed confusion in both arranger and buyer as to the terms and design of structured notes. 117 This concern was raised in the context of other Hong Kong retail­targeted instruments: see P. Lejot, “Cover up! Hong Kong’s Regulation of Exchange­traded Warrants” 36 Hong Kong Law Journal 277 (2006). It would apply also to complex option­based contracts known as accumulators in the context of CITIC Pacific.

36

Structured notes are usually debt obligations, 118 where a holder’s right to income or principal

is tied to the performance of financial or other assets that are contractually and

administratively unconnected to the notes. Any single issue will specify one or more

reference variables whose uncertain outcomes dictate the return on the instrument. They first

appeared in the late 1980s and until recently were purchased by many professional and high

net worth investors. Highly­rated frequent borrowers issued structured notes at the instigation

of leading investors; banks arranged new issues specifically to match the views of their larger

private clients as to the behaviour of interest rates, financial indexes or asset prices.

Structured notes can target retail users, typically by using well­known companies or popular

share issues as reference entities. Some are transparently speculative but others – like

Minibonds – can be designed to seem conservative in their headline terms. Contractual

intricacy and probability­based returns make structured notes problematic to value, as with all

proprietary instruments based on subjective financial modelling. This makes product

comparisons almost impossible for the non­specialist.

3.3.2 Sales to Hong Kong retail buyers

Minibonds were targeted solely to retail customers, using a low nominal purchase price of

around US$5,000 and accompanying “gifts” of inexpensive consumer products or

supermarket coupons. Lehman Brothers’ marketing material for one 2005 issue showed an

Egyptian landscape beneath a cobalt sky, and the slogan: “Just as pyramids are a long­

standing symbol of strength, the Minibond Series 16 combines the strength of Hutchison

Whampoa and five well­known financial institutions to let you invest with peace of mind”. 119

Advertising material for other series used images intended to appeal to retail, including

attractive animals, successful athletes and gold objects.

Most Minibonds were referenced to credit risks, that is, the return on each issue was a

function of the credit standing from time­to­time of specified borrowers, all well­known

Chinese or international companies or banks. 120 Recent issues had between six and eight

reference names; earlier series were linked to one entity or as many as 150 separate

companies. The last completed issue was series 36 in May 2008, which paid quarterly

118 Known as debentures under Companies Ord., s. 2. 119 Emphasis added. Slogans for other series included: “A variety of tenures [sic] producing tasty potential returns”, “sound investment opportunity” and “steady returns”. 120 Separate issues arranged by another bank in Hong Kong used Lehman Brothers as a reference entity.

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coupons of 5.0­5.5 per cent providing that during the three year term of the notes none of

seven reference entities entered bankruptcy or an involuntary reorganisation, or defaulted on

its borrowings. In each case, the notes would be redeemed immediately at a discount to their

face value. 121 Lehman Brothers could also exercise a free call option to redeem the notes

early without compensating the holder for reinvestment losses. The notes were unlisted,

intentionally illiquid, and at any time their value would be opaque.

Taken together, these features mean that a non­retail intermediary would see Minibonds as

inherently costly, and without utility as investments or for hedging purposes. Most non­retail

actors seeking similar speculative exposure would negotiate with an arranger or issuer and

never accept uncompensated credit risk or incomplete disclosure of core terms. The outcome

might be a loss, but any purchase would result from balanced negotiation. Retail buyers lack

any such leverage.

3.3.2.1 The first “Minibonds”

While retail structured notes became noticeable in Hong Kong after the SFC relaxed certain

prospectus rules for unlisted securities in February 2003, 122 the first Lehman Brothers

Minibonds were first launched for sale in Hong Kong in 2002. The total issue size of the first

issue was HK$300 million and was issued via PIFL, effectively controlled by Lehman

Brothers (all subsequent issues were made via this vehicle). This series of Minibonds were

derived from and backed by Hutchison Whampoa’s listed medium­term US$ notes maturing

in 2007. The Minibonds were issued in denominations of HK$50,000 and the subscription

monies in HK dollars were swapped into US dollars to purchase the Hutchison notes, issued

in typical denominations of US$500,000. The Minibonds offered an annual yield of between

5.35 to 5.6 per cent, while the underlying Hutchison notes paid 6.95 per cent. The prevailing

general savings rate was less than 1 per cent.

The issuance of the Minibonds thus provided retail investors the opportunity to invest in the

medium­notes of a blue chip listed company. There was a high degree of transparency as

Hutchison itself and the medium­term notes were both listed. There was also a high degree of

121 A discount linked to the settlement value of credit derivatives for the reference entities. These are widely traded but their price would not be readily available – or intelligible – to retail customers. 122 Mainly to permit repeated issuance under umbrella programmes, with “dual prospectuses” for the programme and each issue.

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regulatory protection in that both the company and the notes had to meet listing and ongoing

disclosure requirements.

3.3.2.2 The term “Minibond” 123

There is much controversy about the marketing of what were in effect credit­linked notes

issued by PIFL using the term “Minibond”, with accusations that the inclusion of the word

“bond” misled investors into thinking that the notes were corporate bonds instead of complex

structured credit instruments. It appears that the term was first used in connection with the

first issue of Minibonds launched by Lehman Brothers via PIFL discussed in the previous

section. 124 Presumably, the term was used to denote the smaller denomination amount of the

notes issued versus the typical denomination amount of bonds.

A review of the Issue Prospectus shows the term “Minibond” being used on the cover page of

the Issue Prospectus together with the series number of the issue, thus the series number reads

“Minibond Series 28”. Moreover, in the section “Our Notes at a glance”, “Minibond Series

28” was used in the first line of the page to read “Minibond Series 28 Notes”. 125 The styled

series number was shown as the issue code elsewhere in prospectus. 126 Other than the use of

the term as described, the term is not used again in either the Issue Prospectus or the

Programme Prospectus.

The term “Notes” was used throughout to describe the debt instrument. In fact, the material

information about the Notes, being the terms and conditions shown in Appendix 1 of the

Issue Programme 127 was headed “Master Terms and Conditions of our Notes”.

123 For the purposes of the following sections, the following are used to provide relevant examples: (1) minutes of the HKSAR Legislative Council (LegCo) Special House Committee Meeting of 13 Oct. 2008 (LegCo Meeting – L/C Paper No. CB(2)25/08­09(2)); (2) Issue Prospectus dated 18 Sep. 2006 issued by PIFL in respect of “Minibond Series 28” (“Issue Prospectus”) (3) the related Programme Prospectus “Secured Continuously Offered Note Programme” dated 20 Mar. 2006 issued by PIFL (“Programme Prospectus”); (4) the notices and circulars of various dates issued by one of the distributors and the trustee following the filing of bankruptcy proceedings on 15 Sep. 2008 by Lehman Brothers Inc. and the consequent triggering of events of default. Analyses and comments may be different in the context of other sources, such as the underlying legal documentation. 124 “Lehman launches mini­bonds to access Hutchison’s yankees”, South China Morning Post, 7 May 2002. 125 Issue Prospectus, supra note 123, p. 3. 126 Id., pp. 1, 5 & Appendices 1 & 3, pp. 24 & 47 respectively. 127 Programme Prospectus, supra note 123, p. 25.

39

Accordingly, the use of the term “Minibond” was limited only in connection with the series

number of the issue. Consequently, there was no misrepresentation in the use of “Minibond”

in the formal documentation.

3.3.3 Minibond structure and purpose 128

Minibonds comprised four commercial elements:

1. An advance by noteholders at the time of purchase. Noteholders acquired claims

against an insubstantive Cayman Islands SPV (PIFL) formed for Lehman Brothers’

use.

2. The purchase of securities as collateral to support the resulting claim. Each issue’s

net proceeds were applied to buying tranches of CDOs from Lehman Brothers with

credit risks matching the reference entities. 129 These provide security for the

noteholders’ claims, and at inception equalled the Minibond issue amount.

3. An array of HK$/US$ interest rate or basis swap contracts between the collateral pool

and Lehman Brothers. This provided the SPV with a single revenue stream matching

the Minibond coupon dates.

4. The sale to Lehman of credit default protection by the pool. The SPV leveraged the

collateral by selling credit protection to Lehman Brothers, entering into CDSs and

thus receiving fees to enhance the revenue available to service minibond claims. 130

Any CDS­related payment due to Lehman Brothers would have priority as a claim on

SPV collateral.

3.3.3.1 CLNs

As is set out in the reports of the HKMA and the SFC, 131 the Minibonds are credit­linked

notes (CLNs). CLNs are normally credit notes issued by banks using a medium term note

128 Minibond prospectuses and other source documents are posted at: http://www.sfc.hk/sfc/html/EN/general/general/lehman/lehman_structure_products.html. 129 CDOs are highly structured debt securities collateralised by pools of conventional or complex claims. Global sales of CDOs to banks and other non­retail buyers were prominent until mid­2007. The drop in confidence then removed liquidity from most structured debt markets and caused a collapse in CDO prices. Their value is currently indeterminate, but in any event will have fallen materially due to a deterioration in credit conditions, see e.g. P. Davies, “Half of all CDOs of ABS failed”, Financial Times, 10 Feb. 2009, quoting market analysts. 130 CDSs are the most common credit derivative contract, used in their simplest form to acquire or protect against credit risks. 131 HKMA Report, supra note 107, para. 2.3; SFC Report, supra note 106, para. 16.1.

40

issuance programme to fund their operations. The principal repayment of the notes is linked

not only to the creditworthiness of the issuer but to third party referenced debt obligation or a

basket of debt obligations via sale of CDS or CDSs. If there is no credit event (the primary

one being credit default), the principal amount will be repaid to the investor of the CLN. A

credit event will trigger the redemption of the CLN, in which case, instead of being repaid the

principal amount the investor will receive delivery of the reference obligation or obligations.

The market value of the reference obligation or obligations will by then most likely be worth

less than the face value of the CLN. During the life of the CLN, the investor will be paid

interest plus the stream of premiums received on the CDS or CDSs paid by the buyer or

buyers of the CDS or CDSs. The investor will thus receive a higher yield on the CLN.

In the case of the Minibonds, the reference entities and their reference obligations are set out

in the Issue Prospectus. 132 According to the Issue Prospectus, repayment of the Minibonds

will be accelerated upon the occurrence of a credit event, defined as “bankruptcy”, “failure to

pay” and “restructuring”, in relation to any one of the reference entities and the reference

obligations. 133 Furthermore, in the event of early redemption due to the occurrence of a credit

event, the reference obligations will be sold via highest bidding. The redemption amount will

be net of realised amounts and costs and expenses.

3.3.3.2 SPV: PIFL

Generally speaking, the firm setting up the SPV, the sponsoring firm, is able to conduct and

finance some of its businesses off­balance sheet via the SPV. Through the conduit of the

SPV, the sponsoring firm could be arbitraging accounting and/or regulatory rules, or

conducting tax­arbitraging transactions, or removing debt from its balance sheet, or

securitising assets/credits. 134 With the exponential growth of securitisation during the past

decade, the last purpose/activity became the most prominent. 135

An SPV is usually a trust, a corporation, a limited liability company or a partnership and

typically has the following characteristics: (1) thinly capitalised; (2) no independent

132 Issue Prospectus, supra note 123, p. 6. 133 Id., p. 7. 134 See G. Gorton & N. Souleles, “Special Purpose Vehicles and Securitization”, NBER Working Paper no. w11190 (National Bureau of Economic Research, Mar. 2005). 135 See sources cited supra note 2 for detailed discussion.

41

management or employees; (3) passive, with administrative functions performed by a trustee

following pre­specified instructions about receipt and distribution of cash; (4) assets are

serviced via a servicing arrangement; (5) structured such that the SPV cannot be bankrupted,

as a practical matter; (6) usually incorporated in one of the tax haven jurisdictions; and (7)

ownership usually vested in charities. 136

PIFL, a limited company, possesses all of the above characteristics. As an “orphan” SPV,

PIFL’s ownership is vested in charities via trusts as disclosed in the Issue Prospectus 137 and

the Programme Prospectus. 138 The trusts are inferred to be blind trusts whereby the executors

have full discretion over the trust assets while the beneficiaries are unaware of the existence

of the trusts.

PIFL’s ownership structure is designed to make it difficult to pierce the corporate veil. It is

arguable that Lehman Brothers was either the sponsoring firm or had such effective control

over PIFL that Lehman Brothers was effectively the sponsoring firm – as much is suggested

by the SFC’s report. 139 Through the structure of ownership, Lehman Brothers was able to

conduct the business of the issuance of the structured products via the conduit of PIFL whilst

avoiding the concomitant liabilities.

As set out in the Issue Prospectus, and this is typical of SPVs set up in connection with

securitisation, PIFL is “bankruptcy remote”, that is, practically it will be difficult to bankrupt

PIFL. 140 This feature affords a degree of protection to the investors of the Minibonds.

3.3.3.3 CDSs

CDSs are private contracts, subject only to the terms agreed, including margin and collateral

arrangements, and are dealt OTC, usually over the telephone, and may in some cases be re­

sold to third parties. CDSs are in effect options, the protection sellers having given the

protection buyers the option to call on the former to take delivery of the papers under the

referenced obligations against payment of the nominal value of the referenced obligations.

136 See D. Arner, “Emerging Market Economies and Government Promotion of Securitization”, 12 Duke Journal of Comparative and International Law 505 (2002). 137 Issue Prospectus, supra note 123, p. 17. 138 Programme Prospectus, supra note 123, pp. 12­13 (“Statutory and General Information about us”). 139 SFC Report, supra note 106, note 12. 140 Issue Prospectus, supra note 123, p. 17.

42

The trigger to exercising the option would be pre­specified events, the main one being credit

default of the reference obligations. Like options, buyers pay premiums to sellers, also known

as spreads in the CDS market.

Usually, the protection buyer pays an upfront amount and then intermittent spreads over the

life of the CDS, typically over a five­year period. The spread payable is based on the

perceived credit risk of the reference entity or the reference obligation and the period of the

coverage. In the current environment of heightened aversion to risk, spreads have increased

substantially.

Benefits of CDSs include: (1) risk hedging; (2) informational value to the market through

pricing of the spreads that could signal the possible financial state of borrowers; and (3)

increasing financial market liquidity and access to capital because of ability of lenders to

hedge. 141 Negative aspects include: (1) the unregulated and opaque nature of the market; (2)

CDS protection leading to looser lending and monitoring standards by banks; (3) the perverse

situation of a lender with protection coverage forcing bankruptcy of the borrower to profit,

resulting in increased cost to the market; and (4) standardisation of documentation and

practices by the International Swaps and Derivatives Association (ISDA) to protect members’

interests. 142

Just as CDSs could provide increased market stability through dispersion of risks, CDSs

could be the point of systemic risk. This arises from counter­party risk, the risk of a

protection seller defaulting on its payment obligations. The failure of one counterparty in a

chain of counterparties would have a domino effect. This is the reason why the US

Government rescued AIG: AIG was a major protection seller; its failure could pose a

systemic risk. 143

Here, two implications flow in relation to the Minibonds: (1) the CDSs sold by PIFL was at

spreads which are now much lower for comparable risks and periods and therefore, a loss will

be incurred in closing out the CDSs; and (2) the synthetic CDOs marked to market will very

141 D. Skeel & F. Partnoy, “The Promise and Perils of Credit Derivatives”, 75 University of Cincinnati Law Review 1019 (2007). 142 Id. 143 See Arner, supra note 2.

43

likely result in huge losses because valuations have fallen substantially since the time the

synthetic CDOs were bought by PIFL.

Note that all the losses and the expenses incurred with the closing out of the CDSs and the

US$/HK$ currency and interest rate swaps will be deducted from the net proceeds from the

sale of the synthetic CDOs. As disclosed in the Issue Prospectus, a Lehman Brothers

subsidiary is the swap counter­party to the CDSs sold by PIFL. 144

3.3.3.4 CDOs

Cash funded CDOs could be described as re­packaging of packaged securities. The initial

packaged securities are asset backed securities (ABSs), which could be made up of residential

mortgage loans, student loans, vehicle loans, corporate bonds and loans and even receivables

from aircraft leases. The re­packaged debts within the CDOs are tranched or layered.

Synthetic CDOs package credit exposures by selling CDSs on a pool of referenced entities

and/or obligations earning spreads from the protection buyers of the CDSs. The monies

subscribed by the investors are usually used to buy high­grade securities, e.g., United States

Treasuries, to be used as collateral backing the CDSs sold. The investors of the synthetic

CDOs are paid the spreads received together with the interest received on the securities, thus

increasing the yield. Synthetic CDOs can be set up more quickly and at less cost than funded

CDOs and higher credit ratings may be easier to achieve.

CDOs and Synthetic CDOs and the tranches or layers within them are rated by credit rating

agencies. The credit ratings are derived from mathematical modellings of tranchings and on

probabilities of defaults and recovery rates. The ratings derived in this way are quite different

from the credit ratings assigned to sovereign and corporate debts, the latter being based

primarily on past and projected business performance to enable assessment of ability to repay

the debts. Credit ratings issues are discussed further below. Suffice it to remark here that the

methodologies of ratings for structured credits have been found to be fundamentally flawed

in some aspects and could be subject to manipulations.

144 Issue Prospectus, supra note 123, p. 18.

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As set out in the Issue Prospectus, the assets to be acquired by PIFL with the subscription

monies are synthetic CDOs. 145 As disclosed in the Issue Prospectus, the synthetic CDOs were

acquired from or through a Lehman subsidiary. 146 Also as disclosed in the Issue Prospectus,

HSBC is the trustee holding on trust for the investors the assets, synthetic CDOs, acquired

with the subscription monies. 147

3.3.3.5 US$/HK$ currency swap and interest rate swap

As set out in the Issue Prospectus, PIFL entered into a master swap agreement with a Lehman

Brothers subsidiary and which was to be supplemented by supplemental agreement for each

series of the Minibonds. 148 The Lehman Brothers holding company was the swap guarantor.

3.3.4 Implications of the structure

Via the conduit of PIFL, an SPV controlled by Lehman Brothers through the flow of

transactions Lehman Brothers fed to PIFL, Lehman Brothers issued the Minibonds and was

effectively the counterparty to the investors, being: (1) the provider/seller of the synthetic

CDOs via a subsidiary; (2) the swap counterparty for the CDSs via another subsidiary; and

(3) also the swap counterparty for the currency and interest rate swaps via the same

subsidiary. Finally, the Lehman Brothers holding company was the swap guarantor. These

material facts and the fact that PIFL possesses all the characteristics typical of SPVs set up as

a passive conduit through which the sponsoring or effective sponsoring firms conduct part of

their businesses, arguably invalidate the statement in the Programme Prospectus to the effect

that Lehman Brothers does not control PIFL. 149

There were two purposes in this structure. Lehman created a tame buyer for its CDOs and

obtained credit protection to hedge its massive securities inventory. Selling Minibonds to

retail was a lucrative by­product. In effect, Minibond buyers sold credit protection in a

similar way to insurer AIG. 150

145 Id., p. 18. 146 Id., p. 17 147 Id. 148 Id., p. 18. 149 Programme Prospectus, supra note 123, p. 13. 150 AIG sold substantial CDS credit protection to banks (see American International Group, Inc., SEC Form 10­ K annual report year ended 31 Dec. 2007, Note 8. Derivatives and Hedge Accounting, p. 164. AIG sought to

45

The commercial bargain for investors is an enhanced return contingent upon there being no

serious credit deterioration in a reference entity, whereupon their claims would be

extinguished at a material discount, free of subrogation rights. Minibond prospectuses show

that the SPV was subject to no restrictions on borrowing: issuance was theoretically limitless.

These arrangements are not unfair in themselves and may be attractive to an informed

reasonable buyer. Minibonds competed for funds with conventional financial instruments but

may be fairly regarded as purely speculative and economically similar to gaming instruments,

notwithstanding their statutory treatment. 151

The structuring provided a degree of protection to the retail investors: (1) PIFL being

bankruptcy remote; and (2) the synthetic CDOs being segregated and held by HSBC, an

independent third party, acting as trustee. Whilst the investors are exposed to the risk of

Lehman Brothers, the investors do not have recourse to Lehman Brothers because of the

corporate veil provided by PIFL. In addition, Lehman Brothers’ claims and all expenses have

been structured to have priority over those of the investors. Accordingly, the claims of

Lehman Brothers arising from being the counterparty to the CDSs and the currency exchange

and the interest rate swaps and all expenses have priority over those of the investors.

Less noticeable to the buyer was a supervening condition in all Minibond issues requiring

Lehman Brothers’ parent to remain solvent. ISDA convention allows the termination of

outstanding swap contracts upon the bankruptcy of a counterparty or its guarantor. Lehman

Brothers’ bankruptcy filing was such an event. If the SPV were to terminate its swaps, the

Minibonds would become subject to mandatory redemption even though no credit event had

occurred among the many reference entities. This leaves a theoretical choice for the SPV,

supervision of which devolves to the Minibond trustee, to terminate the swap contracts or

seek replacement counterparties. Termination forces a sale of collateral, leaving minimal

proceeds for distribution to Minibond holders net of SPV payments due to Lehman Brothers

hedge this short credit risk positions largely by borrowing securities under repurchase (repo) agreements subject to collateral requirements. In Sep. 2008 it became unable to meet demands for greater collateral. 151 No financial instrument is subject to Hong Kong gaming legislation unless the SFC decides otherwise, but such action is unknown. While in Richardson Greenshields of Canada (Pacific) Ltd v Keung Chak­kiu & Hong Kong Futures Exchange Ltd [1989] 1 HKLR 476, predating the Gaming Ordinance (Cap. 148), Sears J found that dealing in certain futures contracts was a “genuine commercial activity”, [1989] 1 HKLR 482, and neither a game nor a bet for a risk­seeking user, the court’s decision relied upon those contracts having uses other than the purely speculative.

46

and the noteholder trustees. Prolonging the swaps avoids a forced sale of collateral and might

improve recovery in the long­term yet is probably infeasible. Replacement has been

discussed in relation to the Singapore Minibonds, but in all cases would be extraordinarily

demanding without state support while Lehman Brothers is being liquidated, given that the

SPV lacks organisational substance. Since the trustee cannot reasonably become active

managers, being bound by the pre­specified instructions in the trust deed, the SPV is unable

to withstand a collapse of the arranger (the effective sponsor).

Lehman Brothers’ filing for bankruptcy set off events of default set out in the underlying

documentation. There has also occurred payment default of the Minibonds. 152 The events of

default have led to the enforced unwinding of the CDS swaps and the currency and interest

rate swaps. The payment default of the Minibonds has led to the enforced acceleration of the

Minibonds. Consequently, the synthetic CDOs will have to be liquidated and the proceeds

applied in priority to pay out Lehman Brothers’ claims and all expenses. The liquidator of

Lehman Brothers will be enforcing Lehman Brothers’ claims (Lehman Brothers being in

liquidation). Upon clearance of the debris from the transactions fed through, PIFL will

transform from a mailbox to an empty shell.

As discussed previously, it is very likely that losses will be incurred liquidating the synthetic

CDOs and the unwinding the CDSs. Given current market valuations, the investors will likely

end up with little or nothing, and the liquidation process of Lehman Brothers will likely take

quite a number of years, given the complexities involved.

3.3.5 Documentation and regulatory concessions

Sales material and Lehman prospectuses warned that Minibonds were “not principal

protected”. This is required by the SFC and intended to suggest caution but the language is

unreliable because it is by definition true of any debt obligation that is not cash collateralised.

In spite of the warning, Lehman was central to the transactions as arranger, swap

counterparty and guarantor, seller and valuer of collateral, SPV sponsor and credit protection

buyer. Yet it was mentioned sparsely in the sales material and without clear explanation in

formal information documents.

152 According to notices circulated by the Trustee.

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As can be seen, compared to the first issue of the Minibonds made by Lehman Brothers in

2002, Lehman Brothers became more aggressive in its structuring of subsequent series of

Minibonds. In respect of the subsequent series, investors were exposed to the risks of Lehman

Brothers, the complexities of the structure and the cross­border nature of the transaction

necessitating complicated legal documentation, the credit risks of the CDSs and the synthetic

CDOs and their characteristics as well as the negative aspects of the unregulated markets for

structured credits.

In the event however the primary risk was that of Lehman Brothers, the effective

counterparty.

Each issue was supported by documents conventional in style and length for complex

securities. Series 36 involved an issue prospectus (54 pages in English), an issuer programme

prospectus (51 pages) with substantially identical content, and a pricing supplement carrying

final terms. Each series received SFC exemptions from Companies Ordinance prospectus

requirements providing buyers were made by a distributor to confirm having read and

understood the issue and programme prospectuses in either Chinese or English. The

concession was granted to many issues made under similar “umbrella” programmes, and

would have resulted from negotiations between arrangers and the SFC. Lehman Brothers

would have argued that financial and other information as to its own standing was readily

available elsewhere, and needed no repetition in documents for each single issue. However,

the effect was to draw attention from Lehman Brothers as the main credit risk, create

obstacles for a prospective buyer from enquiring into the mechanics of the notes, and lessen

emphasis on Lehman Brothers’ centrality in the transaction, not only as arranger but as

commercial beneficiary and legal owner of prior claims on collateral. The transaction purpose

was unstated and difficult to discern.

Prospectuses for most debt and equity new issues include information as to the use of

transaction proceeds, even in the broadest terms and with no covenant as to compliance. 153

The extent or purpose of Lehman Brothers’ core interest in its issues were not disclosed in

Minibond issue or programme prospectuses, which stated only that the SPV would receive a

153 E.g., in Hong Kong to meet the requirements of the Companies Ord., Sch. 3.

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“small fee” for its part in the transaction. 154 Information on Lehman Brothers was contained

in a separate base disclosure document (82 pages) which merely assembled current US

statutory filings. Other transaction documents were listed in the prospectuses as being

available for inspection while the notes were on offer or outstanding. 155 It is unclear that it

would be reasonable to expect an unsophisticated buyer to visit Lehman Brothers’ IFC Two

offices in Central Hong Kong on a working day to read and digest ISDA master agreements,

swap confirmations, details of SPV collateral, or credit protection sold by the SPV. Investors

may not read trustee agreements or exchange listing rules before feeling equipped to buy

bonds or shares, but this case is different in that the transaction’s risk and purpose were

neither simple nor plainly presented. No professional intermediary could have valued the

notes using only the information provided to buyers in prospectuses and marketing material.

SFC prospectus exemptions related in all cases to information on Lehman Brothers.

The secondary risk was the synthetic CDOs. This was a black box, and as set out in the Issue

Prospectus, with the only reliance of PIFL’s promise to acquire “AAA” rated synthetic

CDOs. 156 It has now transpired that for the “Minibond Series 28” the underlying security is

Lehman Brothers related paper. 157

For the “Minibond Series 28”, the reference entities were all well­known global financial

institutions: American Express, Bank of America, Citigroup, Deutsche Bank, Merrill Lynch,

Morgan Stanley and Standard Chartered Bank. In disclosing the credit risks, the reference

entities were set out first, thus emphasising the credit risk of these reference institutions. 158

This both diverted attention and dressed up the actual risks of the structured credit product.

It could be seen how this presentation in the Issue Prospectus together with the use of

“Minibonds” in marketing materials caused confusion, resulting in some investors thinking

that they were investing in bonds of well­known global institutions. This view has been

supported by the SFC: “the marketing materials did not deal with all the risks related to the

154 E.g., Minibond Series 36 issue prospectus dated 14 Apr. 2008, p. 19. Fees were not ordinarily disclosed to buyers. 155 And for photocopying “at a reasonable fee”, see PIFL Programme Prospectus dated 14 Apr. 2008, p. 25. 156 Issue Prospectus, supra note 123, p. 18. 157 Trustee’s notice dated 20 Oct. 2008 providing details of underlying securities; for “Series 28”, “Shares of the Lehman US Dollar Liquidity Fund Institutional Reserve Accumulation Class” (subject to exchange). 158 Issue Prospectus, supra note 123, p. 6.

49

Minibonds and in particular undue prominence was given to the reference entities without

balancing it with upfront risk disclosures about risks related to Lehman Brothers”. 159

3.3.6 Sales practices

Unlike other major financial centres, complex structured financial products such as the

Minibonds were sold to retail investors in Hong Kong. As described in the HKMA report, 160

the practices and requirements in a number of overseas jurisdictions, particularly in the

United States and the United Kingdom, for sale of financial products to retail investors are

more stringent than those currently in place in Hong Kong (as set out in the reports of the

SFC 161 and the HKMA 162 ). In addition, it appears that at least some of the selling institutions

and their staff were engaged in questionable sales practices: Sun Hung Kai Investment

Services, a securities brokerage firm and one of the first of the distributors for the Lehman

Brothers structured products, has agreed with the SFC to refund in full the face value of the

Minibonds to the investors who purchased the Minibonds through them. 163 In the

announcement, the SFC raised four major concerns with the broker: (1) the adequacy of due

diligence on the Minibonds; (2) adequacy of training given to sales staff to enable them to

understand the product and its risks; (3) the record­keeping of investment advice given to

clients; and (4) the assessment of the risk level of the Minibonds.

The corollary from the concerns raised by the SFC must be that it was the SFC that approved

the Issue Prospectus and the Programme Prospectus in the first instance. The issues

surrounding both the approval of the prospectuses and the sales practices of intermediaries

are discussed further below.

159 SFC Report, supra note 106, para. 28.1.2. 160 HKMA Report, supra note 107, s. 7 (“Overseas practices”). 161 SFC Report, supra note 106, s. 8 (“Regime for authorising product documentation) & s. 10 (“Conduct requirements for persons that sell products to the Hong Kong public”). 162 HKMA Report, supra note 107, s. 3 (“Policies and regulations governing the sale of Lehman structured products”). 163 SFC, “Sun Hung Kai Investment Services Ltd agrees with SFC to repurchase Minibonds from its clients at original value”, SFC Enforcement News, 22 Jan. 2009.

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3.4 Responses to the Global Financial Crisis

In addressing the financial regulatory reactions to the crisis, the Financial Stability Forum

(FSF – of which Hong Kong is a founding member) and the Group of Twenty (G­20) (of

which China is a founding member) have been at the forefront internationally. 164 During the

initial stages of the crisis in April 2008, the FSF detailed major regulatory reforms to be

undertaken. 165 Furthermore, during the Group of 7 and IMF/World Bank annual meetings in

October, the FSF reaffirmed the contents of its April 2008 report and also significantly

extended its scope. 166 Both of these reports have subsequently been largely integrated in the

November 2008 statement of the G­20.

In their 15 November 2008 declaration, the G­20 discussed the causes of the crisis,

committed to supporting an open global economy and defined a range of actions to be taken

(under the supervision of G­20 finance ministers) to reform financial regulation to avoid

future crises. 167 The G­20 established five main principles to guide reforms, and the leaders

tasked finance ministers to give highest priority to six areas: (1) mitigating against pro­

cyclicality in regulatory policies; (2) reviewing and aligning global accounting standards,

particularly for complex securities; (3) strengthening the resilience and transparency of credit

derivatives markets and reducing their systemic risks, by measures including the

improvement of the infrastructure of OTC markets; (4) reviewing compensation practices as

they relate to incentives for risk taking and innovation; (5) reviewing the international

financial architecture; and (6) defining the scope of systemically important financial

institutions and determining their appropriate regulation and oversight.

3.4.1 Responding to the Crisis in Hong Kong

Hong Kong has taken a number of measures in response to both the general and specific

impact of the crisis. Following the structure outlined by the Group of Seven in October

2008, 168 Hong Kong has focused its efforts in three areas: liquidity (expanding the HKMA’s

liquidity mechanisms and most recently swap arrangements with the People’s Bank of

164 For detailed discussion, see Arner, supra note 2. 165 FSF, Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience (Apr. 2008). 166 FSF, Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience: Follow­up on Implementation (Oct. 2008). 167 G­20, Declaration: Summit on Financial Markets and the World Economy, Washington DC, 15 Nov. 2008. 168 G­7 Finance Ministers and Central Bank Governors, Plan of Action, Washington DC, 10 Oct. 2008.

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China), depositor protection (blanket guarantee of deposits with AIs via the Exchange Fund)

and capital injections (none to date). In addition, the Hong Kong Government has initiated

the process of analysing weaknesses and devising an appropriate regulatory response.

3.4.1.1 Liquidity

The HKMA has two main channels to provide liquidity to licensed banks in Hong Kong,

namely the Discount Window 169 and the Lender of Last Resort arrangements, 170 both of

which are well established. However, in light of the onset of the systemic phase of the global

financial crisis in September 2008, local financial markets become increasingly affected with

concerns regarding counterparty creditworthiness. Increasing emphasis on the preservation of

adequate liquidity to meet their contingent needs lead to a shortage of inter­bank liquidity.

However, with the onset of the systemic phase of the financial crisis in September 2008, local

markets become increasingly infected with global concerns as to risk counterparty

creditworthiness, and an increasing emphasis by all banks on the preservation of adequate

liquidity to meet their own contingent needs led to a shortage of wholesale market liquidity.

With no bank willing to provide funds to its peers other than on an overnight basis, the most

essential mechanism in the local and global credit system became effectively seized.

The HKMA’s response was common among its developed market counterparts. To relieve

the freezing of interbank liquidity as well as enhancing the framework of liquidity provision

to the banking system, it announced a package of five temporary measures to operate for six

months until 31 March 2009. 171 These comprised (1) broadening of the securities eligible for

use as collateral for liquidity purposes; (2) extension of the maximum duration of liquidity

assistance to three months on request; (3) waiving of penalty rates for use of Exchange Fund

paper as collateral for liquidity provision; (4) commitment to conduct US dollar­HK dollar

169 This is a facility through which local banks can borrow HK dollar funds overnight from the HKMA to meet temporary shortages of liquidity by means of repurchase agreements collateralised with Exchange Fund paper or other eligible securities. 170 Under this arrangement, the HKMA can accommodate demands for funds in times of liquidity shortage by way of either open­market purchases of assets of acceptable quality from the banking sector or making loans through the Discount Window to basically solvent but temporarily illiquid banks usually at above­market rates and secured by good collateral. 171 HKMA, “HKMA to provide liquidity assistance to licensed banks in Hong Kong”, HKMA Press Rel., 30 Sep. 2008.

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foreign exchange swaps with individual AIs when necessary; and (5) availability of

collateralised term lending to banks when necessary.

Shortly after the announcement of the five temporary measures, the HKMA made certain

technical adjustments on 8 October to the formula for calculation of the Base Rate. 172 On 6

November, the HKMA further announced two refinements to the fifth mechanism above, 173

primarily aimed at both further easing term funding pressures encountered by

AIs in Hong Kong and at providing assurances to the market about the availability of

liquidity within the banking system to meet the banks’ increasing needs for funding towards

the year end. These are extending the maximum tenor to three months and rates based on

collateral quality rather than simply market conditions.

3.4.1.2 Deposit guarantee and capital injections

Announced on 14 October after consultation with the Exchange Fund Advisory Committee,

the Financial Secretary introduced with immediate effect until the end of 2010 two new

measures, which were preemptive and precautionary in nature, for the sake of safeguarding

the banking stability, strength and integrity in Hong Kong: a blanket guarantee of deposits

and the creation of a fund to support any necessary capital injections. 174

Under the first, the Government undertook to use the Exchange Fund to enlarge the existing

scope of protection against the amount of all customer deposits held with all AIs in Hong

Kong in excess of that already protected under the existing Deposit Protection Scheme. This

guarantee applies to deposits in both HK$ and foreign currencies with AIs in Hong Kong,

including those overseas institutions having presence with branches in Hong Kong.

Under the second, the Government undertook to establish a Contingent Bank Capital Facility

(CBCF) for the purpose of making additional capital available, on request and whenever

necessary, to locally incorporated licensed banks subject to supervisory scrutiny. The

necessary funds for the injection of CBCF capital into local banks will be drawn from the

172 HKMA, “HKMA to adjust the formula for determination of the Base Rate”, HKMA Press Rel., 8 Oct. 2008. 173 HKMA, “Refinements to the measures for providing liquidity assistance to licensed banks in Hong Kong”, HKMA Press Rel., 6 Nov. 2008. 174 HKMA, “Financial Secretary announces new measures to support confidence in the Hong Kong banking system”, HKMA Press Rel., 14 Oct. 2008 & Annex.

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Exchange Fund. The form and terms of any CBCF capital will be decided on the basis of

individual circumstances, and local banks receiving any such capital will be obliged to accept

conditions or restrictions deemed appropriate by the HKMA to preserve the financial

commitment represented by the CBCF.

By the end of the effective period applicable to the above measures, a decision will be taken

on the basis of assessment of prevailing circumstances existing at the time as to whether it

remains appropriate or justifiable to extend the operations of the above measures.

Commenting on the measures, the Financial Secretary did not expect that such new

arrangements would need to be put into practice, as the local banking system was

fundamentally sound and robust with capitalisation well above international requirements.

Notwithstanding that a series of events around the world caused the Government as well as

the regulatory bodies to act prudently since the onset of the credit crisis, the two measures

were introduced with a view of safeguarding the stability of the banking and monetary system

to some extent.

Following the announcement by the Financial Secretary of the two precautionary measures,

the HKMA published by notice in the Gazette on 24 October 175 guidelines to explain further

the approach of strengthening its monitoring of the activities of AIs in order to guard against

the occurrence of any imprudent or inappropriate business practices and to set out some

examples of circumstances which would attract its supervisory scrutiny in this regard.

3.4.1.3 Reports and reviews

Further, the Chief Executive announced in his 2008­09 Policy Address 176 the establishment

of a new Task Force on Economic Challenges (TFEC) to monitor the impact of the crisis on

local and global markets and to identify proposals to deal with long­term issues. 177 In

addition, at the request of the Financial Secretary, the SFC and HKMA have produced reports

addressing issues arising from the Lehman incident, following which the Financial Secretary

announced that Hong Kong would undertake a comprehensive review of the financial

175 HKMA, “Deposit Guarantee and Contingent Bank Capital Facility”, HKMA Guideline under Banking Ord. s. 7(3) (Gazette No. 43/2008) (24 Oct. 2008). 176 15 Oct. 2008. 177 See http://www.fso.gov.hk/tfec/eng/index.html.

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regulatory system to address both existing weaknesses and support long­term

competitiveness.

3.4.2 Implications for international finance and international financial centres

Preventing and addressing systemic risk is the fundamental aspect of financial regulatory

design. 178 Such design requires the following elements to be addressed: first, a robust

financial infrastructure (especially payment and settlement systems); second, well managed

financial institutions with effective corporate governance and risk management systems;

third, disclosure requirements sufficient to support market discipline; fourth, regulatory

systems designed to reinforce management and market discipline as well as limiting and

monitoring potential risks across all financial institutions; fifth, a lender of last resort to

provide liquidity to financial institutions on an appropriate basis; sixth, mechanisms for

resolving problem institutions; and seventh, mechanisms to protect financial services

consumers in the event of financial institution failure. 179

First, in relation to infrastructure, the central weakness exposed by the crisis has been in

relation to the current bilateral structure of OTC derivatives transactions. In this context, the

bilateral structure resulted in counterparty risks which were not adequately addressed either

by market participants or regulators.

Second, in relation to financial institution corporate governance, in contrast to the

expectations of former U.S. Federal Reserve Chairman Alan Greenspan, 180 financial

institutions did not well manage their own risks or businesses. This is certainly one of the

central failures in the global financial crisis.

Third, disclosure requirements were not sufficient to support transparency and market

discipline. In fact, systemic risks arose due to asymmetric information and understanding –

essentially, weaknesses in transparency and disclosure. Such issues are characteristic of the

highly complex structured products which acted as the transmission mechanism of the

178 See Arner, supra note 75. 179 See generally id., supra note 75. For an alternate view of systemic risk, see S. Schwarcz, “Systemic Risk”, 97 Georgetown Law Journal 193 (2008). 180 A. Greenspan, “Testimony of Dr. Alan Greenspan,” Hearing on the Financial Crisis and the Role of Federal Regulators, House Committee of Government Oversight and Reform, 23 Oct. 2008.

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excesses preceding the crisis and adverse selection issues during the crisis. The activities of

rating agencies exacerbated such issues both prior to and during the crisis. 181

Fourth, in relation to prudential regulation, in most cases, systemic risk did not arise from

areas which were the subject of regulatory responsibility. Rather, in most cases, risks arose

primarily from regulatory arbitrage: exploitation of jurisdictional differences and areas which

were largely unregulated. Examples include mortgage broker activities, off­balance sheet

activities of banks, thrifts and securities firms, hedge funds, OTC derivatives and non­

traditional activities of insurance companies. In these cases, risks often arose from regulatory

arbitrage: financial firms actively moving activities outside of regulated areas. In addition,

such regulatory arbitrage was in many cases made possible by the splintering of financial

regulation across a large number of regulators, with individual regulators usually less

concerned about activities falling outside of the scope of their major responsibilities – an

issue also significant in Hong Kong. Systemic risks also arose due to improperly designed

prudential regulatory standards, especially in relation to capital, liquidity and leverage.

Fifth, systemic risk arose due to the lack of appropriate mechanisms to deal with problems

which arose from unregulated and/or unexpected sources. Examples include the necessity of

rescuing AIG and also the lack of a mechanism for appropriately resolving Lehman Brothers.

In particular, systems are required to deal not only with banks (especially those of systemic

significance) but also mechanisms capable of dealing with non­banks and/or financial

conglomerates.

Finally, consumer protection mechanisms (such as deposit insurance) did not meet the

realities of the domestic financial systems and had to be extended to new areas (businesses

and money markets) in order to prevent new forms of bank run­like withdrawals from core

funding sources of the financial system.

As noted in the first section, preventing and addressing systemic risk is the fundamental

aspect of financial regulatory design. However, financial regulatory design should extend

beyond addressing systemic risk to broader concerns of financial stability. 182

181 See Arner, Lejot & Schou­Zibell, supra note 2. 182 See Arner, supra note 75.

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In looking forward, the current global financial crisis highlights the urgent requirement to

redesign the both global and domestic financial regulatory systems not only to properly

address systemic risk but also to support its proper functioning, i.e. financial stability. The

plan outlined by the G­20 and being implemented by the FSF and others provides a

significant comprehensive outline of the major issues which are to be addressed in this

respect.

At the same time, the plan advanced by the G­20 and being implemented by the FSF does not

provide a significant amount of guidance in respect of the future of finance. As demonstrated

by the role of regulation in the global credit crisis of 2008, financial regulation plays a central

role in the structure of finance, financial institutions and financial transactions.

Whilst the eventual details have yet to emerge, a number of implications appear certain:

1. Policymakers will focus on enhancing the linkage between finance and the real

economy, thus reducing the “financialisation” which was characteristic of global finance in

the years immediately preceding the crisis. In broad terms, finance will become less

significant in the global economy. At the same time, jurisdictions which continue to allow a

more permissive – or at least flexible and adept – approach to finance could eventually

emerge as the major global financial centres.

2. For at least a number of years, financial institutions and transaction structures will

likely become significantly less complex and more transparent. Whilst securitisation and

covered bond structures should return, the more complex products such as CDOs will not

likely be common. Financial institutions themselves will also become significantly less

complex (though not necessarily smaller). These two factors will significantly reduce the role

of offshore jurisdictions.

3. Regulation of unregulated and lightly regulated portions of the financial system will

increase, with the focus on OTC derivatives and hedge funds. The former are likely to move

towards central counter­party structures and/or exchange­based platforms, whilst the latter

will face increased disclosure requirements and leverage restrictions. The shadow banking

system has already largely ceased to exist and is not likely to return in the near future. The

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highest profile example of regulatory structure reform will likely be the United States and the

Eurozone.

4. Quantitative finance, especially risk modelling, will receive much less regulatory trust

and support. This will extend to rating agencies (which will be regulated in various ways) and

their models, but also has important implications for the future of financial education and the

requirements of financial institutions and regulatory agencies.

5. As a result of cooperative efforts, international cooperation and related institutional

structures will play an increasingly important role. Rounding up at this point, the thematic

issue that is emerging from collective global experience, and in particular with the Lehman

Brothers Mininbond incident for Hong Kong, and which the Chairman of the Financial

Stability Forum emphasised in a recent speech in Hong Kong 183 is that of information gaps.

International cooperation at its fundamental level provides exchange of information; such

information, knowledge and understanding must be made to flow horizontally and vertically,

in global and domestic frameworks. Cooperation however is more than exchange of

information, knowledge and understanding but also relates to standards and approaches to

problems both before and after they arrive.

Each of these issues has important implications for Hong Kong.

4. Current Problems and Existing Weaknesses

In seeking to address current problems and existing weaknesses, the first step is an analysis of

the performance of the financial, legal and regulatory system in Hong Kong in the context of

the global financial crisis. From this basis, it will then be possible to discuss consequent

recommendations.

4.1 Evaluating the Performance of Financial Regulation in Hong Kong

During the financial crisis, in the context of financial stability (provided through prudential

supervision and mechanisms to address systemic risk – the central focus of the IMF’s 2003

183 M. Draghi, “Combating the global financial crisis – the role of international cooperation”, Hong Kong, 16 Dec. 2008.

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review), Hong Kong’s financial regulatory system has performed better than most, although

weaknesses in relation to deposit insurance and lack of compensation mechanisms for

customers of failed insurance companies are now evident. However, financial stability

(including prudential regulation) is not the only objective of financial regulation; market

conduct (including disclosure and consumer protection) and competition are other essential

objectives. In these, especially addressing market conduct, the weaknesses of Hong Kong’s

existing financial regulatory system have been seen. At the same time, disclosure issues

surrounding CITIC Pacific, whilst currently unresolved, suggest that Hong Kong’s most high

profile weakness – the relationship between the SFC, HKEx and the Listing Rules – has (as a

result of recent modifications) perhaps not been as problematic as many suspected.

Specifically, the availability of investor actions under the SFO and the implementation of the

dual­filing regime appear to have resulted in an adequate system, albeit one that could be

improved and strengthened.

The most significant aspect is thus the performance of the regulatory system in the context of

the Lehman Brothers Minibonds incident.

4.2 Evaluating Performance in the Context of Lehman Brothers Minibonds

There are two separate though related performance issues which have been highlighted by the

Minibond debacle. The first concerns the regulation and oversight of complex transactions,

especially in terms of contract design, approvals for issuance to the public, and transaction

disclosure requirements. The second concerns regulatory supervision of the behaviour of

intermediaries as regards point of sale matters, notably towards retail clients in the selling of

products and aspects of misselling. Due to the high level of direct participation in financial

trading of individual consumers and investors, both of these problems are of wider

importance to the territory’s financial system.

4.2.1 Approvals for issuance of complex products

As regards authorisation of Minibonds for sale to the public in Hong Kong, in other

jurisdictions, such as the United States and the United Kingdom, the sale of similar structured

financial products to retail investors was restricted due to disclosure and liability frameworks

in those jurisdictions which entailed such potential risks to issues and sellers as to make sales

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to retail unattractive. However, the authorisation framework in Hong Kong is also disclosure­

based, and it is arguable that the existing framework could have been applied in a more

rigorous manner so as to better protect the interests of the investing public. The transparency

of the products could have been improved through compliance with the normally applicable

disclosure requirements. The information exemptions which were in fact granted by the SFC

in connection with the approval of the Minibonds have given rise to a general concern that

the quality of accompanying disclosure may have been insufficient, for example, as regards

Lehman Brothers as the beneficiary of the transactions and their primary credit risk.

A number of questions need to be raised in connection with the authorisation process:

1. Given the complexity of the Minibonds, could any reasonable investor understand

their terms and compared them in terms of expected risks and returns with any

available alternatives?

2. Was reasonable access to transaction information given to buyers?

3. The regulator presumes that with fair information available, the buyer will make a

reasonable decision, and the law assumes a duty of care for the buyer to look beyond

simple marketing material. What then is a reasonable expectation of the buyer, and is

it appropriate for regulators to set standards for product sales that differentiate

between classes of buyer, 184 or disqualify certain such classes from purchasing certain

products?

4. Does an awareness of the speculative nature of a financial contract change over time?

For example, are buyers of Minibonds issued in 2008 less excused than those who

bought notes before the global financial crisis became fully apparent?

None of these questions are answered clearly by current Hong Kong regulation. Retail users

may also be disadvantaged by the general reluctance of the courts to interfere in commercial

bargains, especially those subject to financial regulation. Scholars elsewhere have suggested

that a doctrine of contractual unconscionability might be expanded to allow the court to make

void bargains made between parties that are highly unequal and that are subject to

184 Certain Singapore distributors have offered to unwind sales to those thought most disadvantaged, especially the poorly educated or elderly. The application of such an arbitrary test of suitability involves a categorisation that would in isolation be a controversial test in law.

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information asymmetries that cannot be readily eliminated by the provision of additional data

or supporting material. 185

The SFO, together with rules made by the SFC, categorises certain professional investor

classes, leaving retail as the residual. 186 Retail tends to be associated with an investor

protection ethic exemplified by post­1929 US securities law, and strict disclosure

requirements make structured note sales to US retail investors all but impossible. As with the

approach taken in the United States and the European Union, professional investors in Hong

Kong are defined either by their nature (such as a bank or financial intermediary) or by their

wealth or investment experience (in the case of other types of corporation and individuals).

The obligation is on the regulated firm to know its client. However, the Minibonds were

authorised for distribution to the retail public, which made the professional investor

categorisation irrelevant.

The SFC Chief Executive stated at the Legislative Council on 13 October 2008, that: “The

requirement [for structured note buyers] is to understand the features of the product” and

“[prospective buyers] should ask ‘why does it pay me more than the normal deposit of the

bank?’” 187 At the same time he noted: “These products were backed by triple A collaterals

and the likely cumulative historical rate of failure for triple A collaterals over the past 25

years between 1981 and 2006 is 0.09 percent for the first three years.” 188 The suggestion was

either that the risk of the notes was slight until the insolvency of Lehman Brothers, or that the

SFC had earlier been justified in believing the risks to be so. The SFC was arguably prepared

to grant prospectus exemptions in the belief that the result would be immaterial.

Hong Kong is not the only sophisticated jurisdiction where retail investors may easily buy

complex instruments but it appears to be alone in the disadvantage that its regulatory practice

bestows upon well­intentioned non­professional investors. With SFC approval, far less

185 Notably where intrinsic bargaining imbalances lead to “information processing disabilities” for one party, see M. Trebilcock, The Limits of Freedom of Contract (Harvard University Press 1993). See also H. Collins, Regulating Contracts (Oxford University Press 1999). 186 SFO, Sch. 1; Securities and Futures (Professional Investor) Rules (Cap. 571D). 187 LC Paper No CB (2) 216/08­09, p. 37. The hypothetical comparison with deposits is one that the SFC failed to discourage. 188 Id. The reference to historical default probability resembles an assertion in Lehman Brothers’ issue prospectus for Minibond series 36, p. 54. The statement is misleading in conflating the default performance of all conventional AAA­rated debt issues with those of structured AAA CDOs. Furthermore the use of “backed by” collaterals wrongly suggests that at any time during their life, the amount of the notes outstanding was matched by the value of SPV collateral.

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information was provided on Lehman Brothers than the reference entities in Minibond sales

material or prospectuses, and both Lehman Brothers’ core purpose in the transactions and the

compensation paid to distributors were never disclosed to buyers. Unequal bargaining power

between banks and their retail clients may be unavoidable, but the imbalance between what

may be expected of the reasonable investor – retail or professional – in order to be given a

sufficient picture of complex transactions suggests reforms that could include new and

meaningful regulatory warnings, the standardisation of marketing material to assist

comparisons of competing financial products, revisiting the classification of investors, and

the introduction of pre­execution “cooling off” periods to allow retail buyers time to consider

their actions.

Freedom of contract is upheld only when bargaining clarity prevents an instrument from

becoming unconscionable, where the weight of knowledge needed to make a proper

evaluation of the contract as a financial instrument makes a purchase unfair. 189 Caveat emptor

is a flawed principle if the law fails to ensure contractual completeness, or if supervisors fail

to understand complex instruments or ensure that their purpose and speculative nature is

made explicit.

The foregoing discussion also implies the question as to what gap, if any, exists between

what the current regulatory system provides for, and what is in fact permitted to be done

within that system.

4.2.2 Regulatory supervision of intermediary behaviour

How the selling practices of intermediaries are regulated and supervised leads to a similar

question, as regards how the existing regulatory system operates, or should have or could

have operated.

Once the Minibonds had been approved, the manner in which they were sold into the retail

market has been subject to general criticism particularly as regards: (1) the activities of RIs

(i.e., banks) acting as distributors of the products, including the possibly inappropriate use of

customer / banking information for in respect of securities business – these problems are

discussed further below; and (2) the suitability or otherwise of the products as an investment

189 The Unconscionable Contracts Ord. (Cap 458) applies only to goods and services.

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for particular customers – namely, that investors were sold products which were in many

cases highly unsuitable for them. Both licensed corporations (non­banks directly licensed and

supervised by the SFC) and RIs (who are subject to day­to­day supervision by the HKMA)

are subject to the rules, codes and guidelines published by the SFC. The centrepiece of the

codes regulating the business practices is the Code of Conduct for Persons Licensed by or

Registered with the Securities and Futures Commission (“Code of Conduct”), which applies

equally to licensed corporations and RIs. General Principle 4 of the Code of Conduct requires

intermediaries to “seek from its clients information about their financial situation, investment

experience and investment objectives relevant to the services to be provided” and paragraph

5.2 of the Code of Conduct states that “[h]aving regard to information about the client of

which the licensed or registered person is or should be aware through the exercise of due

diligence, the licensed or registered person should, when making a recommendation or

solicitation, ensure the suitability of the recommendation or solicitation for that client is

reasonable in all the circumstances” (emphasis added). In May 2007 the SFC published a list

of FAQs in which it reiterated that misselling of products should not be engaged in, and

indicated that it regards the primary obligation relating to suitability rests with the

intermediary, not the client. The SFC also stated that instances of non­compliance would be

taken into account when considering whether an intermediary is fit and proper to engage in

the financial planning and wealth management business.

4.2.3 Regulatory performance

These regulatory requirements (including both the authorisation issues discussed above and

misselling), if complied with, would likely have preempted a large number of the Minibond

complaints now being brought to the attention of the SFC and the HKMA. Of course,

procuring compliance is not a straightforward matter and in this regard it is necessary to

consider: (1) the adequacy of powers given to the SFC and HKMA to regulate; (2) the steps

in fact taken to regulate; and (3) the effectiveness of those steps in procuring compliance.

The SFC’s powers to approve offering documents for financial products being offered to the

public in Hong Kong are very clear under both the SFO and the Companies Ordinance (the

latter being the Ordinance of relevance in the case of the Minibonds) and in large part provide

for an effective gatekeeping mechanism. How those powers were in fact exercised in the

context of the Lehman Brothers Minibonds has been discussed above.

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Both the SFC and HKMA have clear powers over intermediaries to supervise and enforce; 190

and, in particular, the SFC has very extensive powers under section 180 of the SFO to

conduct investigations (in the case of RIs it is required under the MoU with the HKMA to

consult with the HKMA before exercising those powers). As regards what steps the SFC and

HKMA have in fact taken to exercise their incumbent powers of supervision, investigation

and enforcement, they have both issued various codes and circulars concerning misselling

and both have engaged in various forms of supervision. To what extent such actions have

been effective, and what hurdles or obstacles they may have had to deal with, deserves

further consideration, as does the effectiveness or otherwise of the current means by which

the securities activities of RIs are regulated (also discussed above).

Any review of the performance of the current regulatory system necessarily implies an

examination of the effectiveness of the regulators in carrying out their regulatory mandate

and identifying any problematic issues in that regard. Such an examination is a central part of

the accountability mechanisms embedded in the regulatory architecture and this is reviewed

further below.

Finally, one of the wider points concerning the significance of the Minibonds incident, and

one which argualby has not as yet been fully appreciated, is the fact that the Minibonds only

really came to be regarded as an important issue upon Lehman Brothers becoming insolvent.

In other words, had Lehman Brothers not become insolvent it seems there would have been

no serious concerns raised over the authorisation and selling of the Minibonds. This is despite

the very large retail market in Minibonds which had developed. What this seems to imply is

that it is quite likely other nascent product / misselling issues exist in the market which have

nothing to do with Lehman Brothers but which are as yet unidentified, and so could be

regarded as problems waiting to happen. If a core feature of the regulatory model is the

identification of problems before they materialise with a view to preventing or mitigating

them, then to the extent this may not be happening reflects a clear gap in the regulatory net.

190 The SFC under SFO, Parts VIII & IX, SFO; the HKMA under the Banking Ord. See also SFC­HKMA MoU, supra note 56.

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From this basis, it is now appropriate to turn to a consideration of the problems and the

immediate needs as regards addressing existing weaknesses, the primary source of both being

Lehman Brothers Minibond­related claims of retail investors.

4.3 Resolving Current Problems and Addressing Existing Weaknesses: Lehman

Brothers Minibonds

To date, as noted above, both the SFC 191 and HKMA 192 have produced reports for the

Financial Secretary identifying and addressing issues raised by the Lehman Brothers

Minibonds incident. The recommendations made by the SFC and the HKMA may broadly be

divided into five categories: (1) the regulatory regime; (2) conduct of business; (3)

information and disclosure; (4) risk assessment in the context of both customer suitability and

products; and (5) dispute resolution and compensation. In addition to recommendations in

each of these areas, consideration of the additional issue of the accountability framework is

discussed in the following sections.

4.3.1 The regulatory regime

The HKMA recommended that the regulatory framework should be strengthened to take into

account the growth in the volume and complexity of investment products sold to the retail

public by AIs and the change in public expectations and risk tolerance by investors in light of

the Lehman Brothers Minibonds incident. 193 It further recommended that all aspects of AIs’

securities business (including registration, standard­setting, supervision, investigation and

sanction) should be placed under the HKMA, and at the same time, coordination between the

HKMA and the SFC be strengthened, with the aim of setting broadly consistent standards of

conduct. 194 By contrast, the SFC’s report observes that an institutional approach to regulation

is now generally considered suboptimal, whilst the “Twin Peaks” approach separating safety

and soundness regulation from conduct of business is attracting more consideration

globally. 195 On this basis, the SFC recommends that the government consider whether Hong

191 SFC Report, supra note 106. 192 HKMA Report, supra note 107. 193 Id., Recommendation 4. 194 Id., Recommendation 9. 195 See section 5 infra for full discussion of issues relating to regulatory structure.

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Kong’s current regulatory structure is best suited to facilitate its further development as an

international financial centre. 196

Overall, the SFC’s recommendation (already initiated by the Financial Secretary) for a full

regulatory review is clearly necessary (an issue discussed further below). In the context of the

regulatory review, it no longer makes sense in light of experience to separate securities

regulation into two regulatory authorities: responsibility for regulation of banks’ securities

activities should be transferred to the SFC, with the HKMA remaining as the prudential

regulator of banks.

4.3.2 Conduct of business

The HKMA recommended that AIs should continue to be permitted to undertake securities

business (including selling investment products to retail customers), but steps should be taken

to ensure clearer differentiation between their traditional deposit­taking activities and retail

securities business. Recommended measures include: (1) the physical segregation of AIs’

retail securities business from their ordinary banking business; (2) requirement that staff

involved in selling investment products to retail customers should not be involved in ordinary

banking business; (3) requirement that AIs make clear through physical signs and warnings

the distinction between deposits and investments, particularly the risks attached to the latter:

(4) requirement that there be complete information separation between a retail customer’s

deposit accounts and investment accounts; and (5) as well as a prohibition on AIs making use

of deposit­related information to target and channel retail customers into investment

activities. 197 The HKMA further recommended that this segregation should apply to AIs’

insurance and other investment activities. 198 The recommendations are similar to those made

by the SFC, that the structure of banks’ securities operations should be reviewed to see how

best to provide clear differentiation of banking services from securities services. 199

Whilst these recommendations acknowledge the fundamental problem that has become

evident in the Lehman Brothers Minibonds incident, they do not address it – AIs are able to

leverage their branding and reputations from the traditional banking activities for the

196 SFC Report, supra note 106, para. 21.3. 197 HKMA Report, supra note 107, Recommendation 10. 198 Id., Recommendation 11. 199 SFC Report, supra note 106, para. 22.5.

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purposes of promoting their securities business. The often long­standing relationship between

banks and their customers and the reliance customers place upon banks for these services

means that investors who engage in their bank’s securities services may be less guarded than

they would be if they were engaging a less familiar intermediary for the same services.

Effective segregation of the AIs’ traditional banking activities and securities activities should

only be the starting point. While for inexperienced investors and in respect of complex

products, additional requirements such as the seeking of independent financial advice could

be imposed to ensure that there is no undue reliance or influence arising out of a preexisting

bank­customer relationship on the part of the investor, this is probably not practicable. Along

with segregation, however, should go strengthened training requirements for staff selling

non­banking products and services, with strengthened liability frameworks provided through

the legal and regulatory system applying to individuals, management and institutions in order

to secure compliance and incentivise appropriate customer treatment.

As specific examples supporting such an approach, at the point of sale, the HKMA

recommended that regulatory requirements should be reviewed with a view to introducing

mandatory requirements for the audio­recording of the sales process and ancillary

arrangements. 200 The SFC recommended that: (1) intermediaries conduct self­examination of

their controls and procedures to ensure that these provide senior management with sufficient

assurance they meet their general obligations under the Code of Conduct, including that their

staff receive adequate training; (2) products only be sold by staff that have demonstrated

sufficient understanding of the particular product; (3) the rationale underlying the

recommendations and solicitations made to a client be documented and copied to the client;

and (4) product due diligence be conducted on a continuous basis at appropriate intervals. 201

Contemporaneous records of the sales process have thus emerged as an issue to be addressed

by the recommendations of the regulators. Given the allegations of misselling by the Lehman

Brothers complainants, this should hardly be surprising. The issue that arises is whether or

not further to such contemporaneous records, the regulation of sales needs to be strengthened

with statutory backing. At present, the sales process is regulated through the Code of Conduct

as well as various guidelines, and common law principles of contract law such as

200 HKMA Report, supra note 107, Recommendation 13. 201 SFC Report, supra note 106, para. 33.6, sub­paras 33.6.1­33.6.4.

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misrepresentation may apply. The deterrent effect of the regulatory regime against misselling

may further be strengthened by addressing the existing disconnect between a breach of the

provisions of the regulatory regime and compensation by codifying regulatory duties to give

rise to private rights of action. The suitability and misselling framework currently embedded

in codes and guidelines needs to have statutory backing as well as allowing a simpler

mechanism for investors to pursue sellers directly.

Further recommendations in respect of sales including the requirement of a cooling off

period, 202 introduction of mystery shopping to test sales conduct, 203 and consideration as to

whether there should be restrictions on the use of gifts as a marketing tool to promote

financial products to investors 204 were also made.

Of note were the HKMA’s Recommendation 18 and the similar paragraph 31.6 in the SFC’s

report, whereby remuneration structures for staff engaged in AIs’ securities business be

subject to greater focus in the HKMA’s on­site examinations and off­site surveillance, and

the SFC would review requirements for comprehensive disclosure to clients at the pre­sale

stage of commissions, fees and other benefits the intermediary receives from the sale of the

products it recommends or is offering to clients.

The issue remains how the apparent conflict of interest between the commercial/remunerative

benefits to bank and staff in selling securities and the risk investors face in purchasing

securities is to be resolved, revealed particularly by the Lehman Brothers Minibonds incident.

As noted above, the intersection between the regulatory regime and private rights of action is

weak, a fact that appears contradictory set against one of the primary aims of the regulatory

regime is investor protection.

4.3.3 Information and disclosure

Appropriate market disclosure for proper risk assessment is and will always be the central

consideration in public securities offerings. The appropriate level of disclosure must be

transparency to the degree that the buyer is a true willing buyer. Accordingly, it is the setting

202 HKMA Report, supra note 107, Recommendation 15; SFC Report, supra note 106, para. 32.6. 203 HKMA Report, supra note 107, Recommendation 17; SFC Report, supra note 106, para. 23.7. 204 HKMA Report, supra note 107, Recommendation 7.

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out and explanation of all and what the subject matters are, their characteristics and what

potential factors could have an impact, all in simple and comprehensible language.

The first recommendations the HKMA made were that the policy objectives on which the

disclosure­based system for investor protection rests are appropriate for Hong Kong and

should be retained, and the Government should reaffirm those policy objectives. 205 Similarly,

the SFC recommended that Hong Kong maintain the regulatory philosophy of disclosure

coupled with conduct regulation of intermediaries rather than merit regulation, and through

investor education, advise investors what SFC authorisation of a product means. 206

While disclosure is the most appropriate basis for investor protection, the effectiveness of the

disclosure regime, however, is questionable – disclosure ensures neither understanding nor

appreciation of investment products and the risk they represent to investors. In respect of the

Lehman Brothers Minibonds, for example, the prospectuses could not be said to be helpful in

the sense of making disclosures to the extent of transparency for potential investors to assess

properly the risks. The documents are more for the protection of the issuer. Arguably only

specialists in banking, securities and law would have been able to understand the intricacies

of the documentation. It is thus doubtful whether investors could and would read the

documents. Even the extent of the understanding of the staff of the distributors is

questionable.

Further recommendations in respect of disclosure and investor education were made. The

HKMA recommended that “health warnings” be attached to retail structured products with

embedded derivatives or to retail derivative products generally, 207 and that uniform disclosure

formats such as simple “product key facts statements” and “sales key facts statements”

should be required to be produced in respect of such products (and indeed other retail

investment products). 208 The SFC makes a similar recommendation in the development of

requirements for summaries for structured products in no more than four pages of plain,

205 Id., Recommendations 1 & 2. 206 SFC Report, supra note 106, paras. 24.9.1 & 24.9.2. 207 HKMA Report, supra note 107, Recommendation 5. 208 Id., Recommendation 6.

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concise, easily understood language, augmented by charts and diagrams. 209 These summaries

should include all key information and facilitate comparisons with other products. 210

Whilst the recommendations are directed at enhancing understanding, it is questionable

whether such a simplified approach could in substance achieve the objective and would

instead have the effect of creating a false sense of appreciation of risk.

In respect of the Minibonds, neither the risk statements in the Issue Prospectus 211 nor the

Programme Prospectus 212 and the Appendix 2 “Derivatives” referred to and described

directly and specifically the risk characteristics of the CDSs and the Synthetic CDOs. What

Synthetic CDOs that were to be purchased were not disclosed in the Issue Prospectus. There

was a mere promise 213 to buy the Synthetic CDOs. Consequently, and this is stated in the

Issue Prospectus, 214 investors must rely on the criteria by which the Synthetic CDOs are to be

chosen, that is “AAA”, to make their investment decision. The investors thus did not know

what was acquired, and there was no independent verification agent on what was acquired

met the criteria and on valuation. In respect of credit ratings, the information given in

Appendix 2 “A brief guide to credit ratings” in the Issue Prospectus 215 was about assignment

of ratings to corporate debtors. Thus, the information is irrelevant and misleading. There was

also missing or incomplete information, e.g., the aim of referencing to the subordinated notes

was to be paid a higher premium on the CDSs. The failures of either report to address these

issues indicate a lack of proper and adequate knowledge and understanding about disclosure

of the quality that would provide the necessary transparency to make properly informed

investment decisions.

Supporting this, the results of a survey carried out by the SFC, that two­thirds of those

surveyed admitted they were unfamiliar with at least one of the products they had invested in,

but yet almost half expected some return with little or no loss, 216 appear to indicate that the

underlying attitude of investors also needs to be addressed.

209 SFC Report, supra note 106, para. 26.6. 210 Id., paras. 26.6.1 & 26.6.2. 211 Issue Prospectus, supra note 123, p. 14 (“Investment Risks”). 212 Programme Prospectus, supra note 123, p. 17 (“Investment Risks”). 213 Issue Prospectus, supra note 123, pp. 15, 17 & 18. 214 Id., p. 15. 215 Id., p. 41. 216 “SFC survey reveals unrealistic investors”, South China Morning Post, 2 Dec. 2008.

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Other recommendations in respect of disclosure include the review of the private placement

regime, 217 amending the SFO to set a single overall disclosure standard for all offering

documents which would be enforceable against the persons responsible for offering

documents, 218 revisiting the issue of whether the two public offering regimes for investment

products should be retained in Hong Kong and consideration as to whether existing

exemptions from SFC authorisation of offering documents are too broad, 219 and the revision

of the SFC’s published guidance on marketing materials to ensure the materials are correct,

properly balanced and not misleading. 220

Furthermore, the HKMA also recommended that public education campaigns regarding the

policy objectives of the disclosure regime should periodically be undertaken, with an

emphasis on the responsibilities of investors, intermediaries and regulators, 221 whilst the SFC

recommended an Investor Education Council be set up as soon as possible for the purposes of

enhancing financial literacy in the public. 222 As a counterpart to disclosure, education is a

necessary component for promoting greater understanding of financial services, investment in

particular. It remains questionable – perhaps very questionable – how receptive the public

may be to such education, and, as stated above, academic understanding should not be

equated with an appreciation of risk. The expectation of reward, as surveyed, must be

tempered by the fostering of public understanding that risk needs to be actively managed, and

the importance of independent financial advice should be emphasised in the development of

an individual investor’s investment and risk strategy.

One recommendation in respect of disclosure that does not push the onus back upon the

investor is to be found at paragraphs 27.3­27.4 of the SFC’s report. The SFC recommended

that requirements be introduced to the SFO to ensure issuers of investment products provide

relevant information for investors including price information and changes in circumstances

that may have a significant effect on the value of the investment. 223 The SFO should also be

amended such that intermediaries must take appropriate steps to ensure that this information

217 HKMA Report, supra note 107, Recommendation 8. 218 SFC Report, supra note 106, paras. 25.5.1 & 25.5.2. 219 Id., paras. 25.6.1 & 25.6.2. 220 Id., para. 28.7. 221 HKMA Report, supra note 107, Recommendation 3. 222 SFC Report, supra note 106, para. 38.4. 223 Id., para. 27.3.1.

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is brought to the attention of investors. 224 Finally, the SFC recommended that the SFC’s

website become a repository of information about unlisted investment products that have

been authorised by the SFC. 225 The requirement of providing updates to investors is a more

pro­active approach to disclosure that should be applied more broadly.

In the case of the Lehman Brothers Minibonds, it cannot be said that the disclosures in the

Issue Prospectus or the Issue Programme meet the standard of disclosure to the degree of

transparency that the investors were true willing buyers. The Minibonds were of complex

structuring necessitating complicated legal documentation. The underlying securities were

highly complicated structured credit instruments. The disclosures were rudimentary assessed

against the complexities. There was more opacity than transparency.

By comparison, in the case of the first Minibond issue, there was a high degree of

transparency. It was more coincidental and indirect than by design. It so happened that the

underlying security from which the Minibond was derived and backed by was Hutchison

Whampoa notes. Both the issuer and the notes were listed on the HKEx.

Overall, in this context, three main points emerge: the need for increased investor education;

the need for increased requirements relating to staff and selling institutions in respect of

suitability; and the need for not only increased disclosure but also strengthened legal and

regulatory mechanisms to allow both regulators and investors to protect their interests

directly.

4.3.4 Risk assessment

The assessment of risk was central to the Minibond incident, in particular, the identification

of risks associated with complex investment products, and the scale of risks that investors are

prepared or permitted to tolerate.

The HKMA recommended that where the continuous review by a registered institution of the

risk ratings of the investment products it sells results in a higher risk rating being attributed to

a product, the institution should disclose this to customers to whom it recommended and sold

224 Id., para. 27.3.2. 225 Id., para. 27.4.

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the product. 226 In view of the criticisms of the credit ratings agencies (as noted above and

discussed further below), it is perhaps somewhat surprising that the HKMA would

recommend to continue to rely upon such ratings. The difference between credit ratings for

corporate debts and structured credits was a key aspect of the Minibonds; that “AAA” rating

of assets to be purchased, used and emphasised in the marketing of the Minibonds, and

presumably was the main criterion for risk assessment and investment decision by the

investors, was misleading and thus led the also disclosures to be misleading. Even if (as

seems probable) credit ratings agencies are to be regulated in future, reliance upon such

ratings should be avoided. Rather, investors should be expected to undertake their own

analysis but at the same time to be able to take action (or for regulators to take action on their

behalf) against issuers and sellers of financial products.

Assessment is not limited to products, but extends to the risk profiling assessment of

investors as well. In this regard, the SFC has recommended that it would review the

“professional investor” definition and consider whether the minimum asset portfolio

requirement and assessment criteria under the Code of Conduct remain appropriate. 227 Whilst

there is no doubt that the definition of “professional investor” in Hong Kong should be

revised, it is questionable whether or not this revision should simply focus on raising the

existing standards or whether new considerations need to be brought into the definition. Of

particular concern is the emphasis upon asset size, which is not necessarily an accurate

indicator that there is a sufficient level of understanding of investment products or

appreciation of risk. Classification of investors should be made with greater reference to

direct product or market segment knowledge and experience rather than merely with

reference to worth or means. In this context, an investor’s ability to carry out due diligence

and its access to independent advice may be especially important.

The SFC also recommended that the requirements for intermediaries to adopt suitable criteria

for characterising investors to ensure advice and products offered are suitable for the

individual investor be brought forward. 228

226 HKMA Report, supra note 107, Recommendation 14. 227 SFC Report, supra note 106, para. 29.7. 228 Id., para. 34.3.

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The HKMA’s recommendations on customer risk follow on from their recommendations of

segregation between the banking and securities business of banks. The HKMA recommended

that assessment of customer risk profiles be separated from the sales process and be carried

out by non­sales staff with mandatory audio recording requirements. The customer should

also be provided a copy of the profile and asked to confirm its accuracy. 229 Furthermore,

where there has been a mismatch between the risk rating applied to the product and the

customer’s risk profile, full and complete documentation should be retained as to why the

customer made the investment decision. The sales process should be audio­recorded, and

endorsement should be sought from qualified supervisory staff within the institution. 230

Again, there is an emphasis in these recommendations on contemporaneous recording of the

sales process raising the issue of statutory backing for the suitability and misselling

framework.

Finally, given the reliance placed upon customer risk profiling, any reclassification of

professional investors could include a spectrum of investor types, similar to the approach in

the European Union adopted under the Markets in Financial Instruments Directive

(MiFID). 231 This would offer the advantage of more uniform customer risk profiling between

intermediaries and institutions, and could in turn have an effect on the level of independent

advice required for each class of investor.

Along with risk goes pricing. Pricing is compensation for the risk investor is prepared to bear.

There is also the lesser element of the risk and the administrative cost of the producer/seller

of the financial service.

In the case of the first Minibond issue, it could be said that there was transparency with

pricing, which could be gauged against that of the underlying Hutchison note. It could also be

said that the pricing was commensurate with the risk. For the later issues of Minibonds, the

pricing was opaque. There was no disclosure of valuations of the structured credits.

Furthermore, the investors were exposed to the risks of Lehman Brothers, the complexities of

the structuring of the transaction, the structured credits and markets and the credit ratings.

229 HKMA Report, supra note 107, Recommendation 12. 230 Id., Recommendation 15. 231 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC, OJ L 145, 30.4.2004.

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4.3.5 Dispute resolution and compensation

The recommendations in this area are considerably more limited than those of other areas.

The SFC recommended that the SFO be amended so that orders could be made under section

213, which allows the SFC to seek injunctions and other orders from the Court for breaches

of the Code of Conduct. 232 The SFC further recommended that the SFO be amended to

empower the SFC to impose compensation orders as a disciplinary sanction. 233 These

recommendations go some way in addressing the disconnect between the regulatory regime

and investor compensation. Further consideration should be given to the extension of the

rights in sections 281 and 305 of the SFO to damages through civil suit for the contravention

of the market misconduct regime in Part XIII and the offence provisions in Part XIV

respectively to the Code of Conduct and other relevant parts of the regulatory regime. This

would simplify the process by which compensation may be sought, as it would be clear from

the legislation what causes of action may lie without having to consider the confusing

intersection between the rules and common law causes grounded in contract or tort law or

even other consumer protection provisions which may potentially apply.

Both the HKMA and the SFC put forward the idea of an ombudsman for financial services –

the HKMA took into account international practice and the desirability of having a focused,

specialised organisation with powers to adjudicate or settle disputes between investors and

intermediaries, and recommended that the establishment of a dispute resolution mechanism

for the financial industry along the lines of a financial services ombudsman should be

considered. 234 Similarly, the SFC recommended that the Code of Conduct should be amended

to require client agreements specify a right for clients to have their grievances resolved by a

dispute resolution procedure and the Government should review the need for a financial

ombudsman to provide a dispute resolution procedure for aggrieved investors. In light of the

more rapid action taken in Singapore in respect of compensation, 235 and the limited progress

232 SFC Report, supra note 106, para. 39.4.2. 233 Id., para. 40.7. 234 HKMA Report, supra note 107, Recommendation 19. 235 “Singapore ruling on minibonds brings HK hope”, South China Morning Post, 17 Jan. 2009.

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in respect of voluntary settlements, 236 particularly on the part of the banks, it is clear action is

necessary, both for the present complainants as well as for dealing with dispute resolution

and compensation in future. In this context, an overall mechanism for addressing consumer

financial services complaints is appropriate, whether through an independent ombudsman or

through restructuring of market conduct regulation to include this function explicitly across

the financial sector.

The scale of the Lehman Brothers Minibonds problem highlights a particular weakness in the

existing consumer complaints and dispute resolution regimes – the capability to cope with

high numbers of complainants.

At present, four options appear open to complainants – litigation, arbitration, mediation, and

negotiation.

As stated in the Legislative Council brief in respect of the Civil Justice Reforms, which come

into force on 2 April 2009: “The procedural system of justice in Hong Kong is adversarial

based, meaning that the courts will leave it to the parties themselves to bring cases to court

and on the whole let them define the nature and extent of their dispute”. 237 Litigation has in

fact begun, 238 including possible involvement of Hong Kong investors in a class action suit in

the United States, but the complexity of the Lehman Brothers bankruptcy as well as

overlapping civil law and regulatory regimes mean it will be some time before any court is

able to come to a decision and even longer for a final result to emerge from any appellate

process. The difficulties in respect of cost and timeliness of litigation in Hong Kong are

further compounded by the more stringent standards applied to representative actions. 239 The

test to be applied is that there must be “a common interest, a common grievance and a

remedy which is beneficial to all the plaintiffs”. 240 Such actions cannot be brought unless the

whole of the claim is appropriate to the form of action. Whilst a general complaint of

misselling may be common to the complainants, the variations of the Minibonds involved and

236 “Talks on US legal obstacle to buy­back of minibonds”, South China Morning Post, 28 Nov. 2008; “Minibond deal raises pressure for more refunds”, South China Morning Post, 24 Jan. 2009. 237 Legislative Council Brief, Subsidiary Legislation Relating to the Civil Justice Reform (JUD ADM 1­55/2/9) (2 Apr. 2009), para. 3. 238 “Illiterate minibond investor files writ”, South China Morning Post, 4 Dec. 2008; “Tribunal adjourns 12 cases relating to minibonds”, South China Morning Post, 29 Dec. 2008; “Two women sue bank over minibond losses”, South China Morning Post, 11 Jan. 2009. 239 For further in respect of representative actions, see Rules of the High Court, Order 15, Rule 12. 240 J. Bollinger S.A. v Goldwell Ltd., H.P. Bulmer Ltd. v J. Bollinger S.A. [1971] R.P.C. 412.

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specific circumstances of sale and factors that are personal or individual such as investment

experience, level of education etc would enable defendant institutions to raise objections to

actions being brought as representative.

Further to the disadvantages in respect of time, cost and the complexity of the legal issues as

mentioned above, the major hurdle presented is the difficulty in unbundling the Minibonds.

Whilst the civil standard of proof is only on the balance of probabilities, the onus of proof

remains with the complainant, who is at an informational disadvantage when compared with

the distributors that may not necessarily be overcome by discovery alone, but may require the

services of expert witnesses as well.

On 31 October 2008, the Hong Kong International Arbitration Centre (HKIAC) announced

its appointment by the HKMA as the service provider of the Lehman­Brothers­related

Investment Products Dispute Mediation and Arbitration Scheme. 241 As the HKIAC explains:

“Arbitration is a legal process which results in an award being issued by the arbitrator or

arbitrators. Arbitration awards are final and binding on the parties and can only be challenged

in very exceptional circumstances”. Arbitration is less formal than litigation, but must still

follow arbitral rules and procedure of some form, with the notion that an arbitral award

rendered by a third party who may be nominated for their knowledge or expertise may be

somewhat fairer than a judgment rendered by the Court. Given the complexity of the issues in

this context, there may be difficulty in finding arbitrators who are capable of dealing with the

interacting regimes of civil law, the bank­customer relationship, and the regulatory regime, as

well as understanding the Minibonds themselves – the invitation of the HKIAC to members

of the Bar 242 (emphasising prior mediation experience in particular but without reference to

knowledge of the relevant issues, laws, codes or regulatory regimes) to apply to join the

Scheme on 17 November 2008 seems to highlight this difficulty. Moreover, given the

similarities between arbitration and litigation, it may prove difficult for a class of

complainants to arbitrate their complaints simultaneously, necessitating an individual, case­

by­case approach which is liable to be both time­consuming and to produce inconsistent

awards – indeed, the Notes to the Scheme emphasise the individual nature of the claim. 243 As

representation by legal professionals or other representatives is not a prerequisite of

241 HKIAC, Press Rel., 31 Oct. 2008. 242 Hong Kong Bar Association Circular No. 118/08, 17 Nov. 2008. 243 HKIAC, Notes, Lehman­Brothers­related Investment Products Dispute Mediation and Arbitration Scheme, para. 2.

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arbitration, the information gap between distributors and complainants is potentially

significantly widened. The private nature of arbitration means that decisions and awards may

not be disclosed, leaving complainants and the regulatory authorities in the dark as to

reasoning and the range of compensation.

Of particular concern in the arbitral process is the fact­finding exercise, which is again

adversarial and places the onus upon the party that is likely to be at the greatest informational

disadvantage.

As stated above, the HKIAC has been appointed in respect of both arbitration and mediation.

On 22 December 2008, the HKIAC announced the first successful mediation of a Lehman

Brothers Minibond complaint. 244 On 19 February 2009, the HKIAC announced a 100 per cent

level of success had been achieved for Lehman Brothers­related investment product cases, 245

stating that 10 cases were settled by direct negotiations between the investors and banks after

mediation had been requested and in 10 other cases, mediation proceeded to settlement

agreements. However, mediation is a dispute resolution process based less upon the disputed

issues and with an emphasis on a negotiated outcome – as is demonstrated by the HKIAC’s

press release, the measuring stick for success was the mere fact that an agreement was

reached, as opposed to the amount of compensation that was achieved for the aggrieved

party. Such an approach may leave complainants at a disadvantage as the balance of

bargaining power and information is not on their side. The mediator represents neither side,

and complainants without the assistance of legal representation or other advisers will again be

placed at a severe informational deficiency, which could disadvantage them greatly as

negotiation no longer takes place on equal footing. Nor is mediation well­suited to situations

involving high numbers of individuals with complaints, as the relevant factors to be

considered for the purposes of negotiation may differ from complainant to complainant.

Negotiation is the least formalised and arguably least expensive method of resolving disputes,

involving direct negotiations between the parties. As stated above, negotiating difficulties

faced by Lehman Brothers Minibond complainants are clear, as they lack considerable

bargaining power and access to information. A number of assisted negotiations have led to

settlements – 60 noteholders received some HK$30 million in compensation with the

244 HKIAC, Press Rel., 22 Dec. 2008. 245 HKIAC, Press Rel., 19 Feb. 2009

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assistance of the Democratic Party. 246 However these represented some of the most

vulnerable complainants – characterised as “elderly, less educated, [with] little investment

experience and [having] invested considerable amounts of their savings”, involved

“regulation violations” and were arguably the most abject cases for immediate recourse to the

courts or other forms of resolution. The average amounts recovered by complainants was

characterised as “high” but not disclosed.

The HKIAC and Democratic Party results are based on the achievement of an agreement

between the parties, without going into the actual levels of compensation agreed. As has been

noted above, Sun Hung Kai Investment Services has voluntarily offered to repurchase

Minibonds from its clients at a price equal to the principal amount invested, with the SFC

raising a number of concerns in respect of Sun Hung Kai’s Minibond sales practices forming

the basis of an SFC reprimand and Sun Hung Kai’s offer. With a precedent having been set

by the Sun Hung Kai settlement and the very real possibility that similar concerns may exist

in respect of the sales by banks, the issue arises as to whether compensation levels achieved

by arbitration and negotiation result in comparable treatment.

As the Law Reform Commission considers the appropriateness of class action suits for Hong

Kong, other mechanisms need to be introduced whereby common, widespread complaints

may be dealt with, perhaps through a standardised arbitration system, through an ombudsman

or through the structuring of a comprehensive market conduct regulator.

A key issue that arises from the complexity of the Lehman Brothers Minibonds incident is

whether or not the fact­finding process in an adversarial system is appropriate, or whether an

inquisitorial process would be better for addressing the information imbalance. It may be

necessary to strengthen the links between investigations and fact­finding procedures for

regulatory purposes, such as disciplinary actions, and private rights, again returning to the

issue of disconnect between the regulatory and civil law regimes.

More importantly, it is clear that a complaints­based approach dealt with by way of a

multitude of individual court cases, arbitrations and mediations will result in a painfully slow

process that not only appears set to drag on for some considerable time, but will give rise to

246 “60 investors get HK$30m from banks on minibonds”, South China Morning Post, 10 Dec. 2008.

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wildly varying rates of compensation, limits the transparency of the compensation process

and introduces a high level of unpredictability. Inconsistency in the quality of justice that

aggrieved investors receive will not only damage Hong Kong’s reputation as a centre for

dispute resolution, but also harm its competitiveness as a financial centre.

For the purposes of compensation, a system for the identification and categorisation of

different classes of investors based upon factors relevant to the common complaint must be

developed. In respect of the Minibonds incident, for example, where the common complaint

is misselling, it would be appropriate to separate the complainants into different classes

depending on factors such as age and investment experience, education level, and ability to

carry out due diligence or access to independent financial advice. This would allow for

common standards of compensation to be applied to classes of investors, eliminating the

inconsistency of the compensations derived thus far through the various methods.

4.3.6 Accountability framework

A fundamental element of any regulatory system is a certain level of independence for

regulatory organisations in the conduct of their assigned responsibilities. This independence

however must be backed by an appropriate framework of accountability for performance in

their assigned remits. 247 The reports of the SFC and the HKMA considered above have been

prepared primarily for the purpose of facilitating a Government review of the existing

regulatory regime including the investor protection framework in the context of the Lehman

Brothers Minibonds. 248 In the case of the SFC, the report presumably arises out of a request

made by the Financial Secretary under section 5(1)(q) of the SFO which provides that the

SFC is “to advise the Financial Secretary on matters relating to the securities and futures

industry and provide him with such information in relation thereto as it considers

appropriate”. In the case of the HKMA, the report has presumably been furnished under

section 9(3) of the Banking Ordinance which provides that the HKMA “shall, at such times

as he considers necessary, report to the Financial Secretary on improvements that he

considers to be desirable in the operation and management of his office.” These statutory

247 These issues are discussed extensively in the IMF’s 2003 review, supra note 74. For general discussion, see Arner, supra note 75. 248 See SFC Report, supra note 106; HKMA Report, supra note 107.

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provisions reflect an important aspect of the regulatory architecture within which the SFC

and the HKMA operate as regards regulatory reform and accountability.

Both reports focus on the current structural framework of laws and regulations. It goes

without saying that laws and regulations must be pursued by the supervisors of intermediaries

and enforcers (i.e., regulators) with all appropriate due diligence if laws and regulations are to

be of any value. This is particularly important in the modern regulatory context, a central

objective of which is the preemption or mitigation of problems prior to their occurrence. This

preventative aspect is at the heart of the concept of codes of practice and prudential

supervision.

Accordingly, there is a second important aspect of the accountability framework set out in

both the SFO and the Banking Ordinance. In the case of the SFC, section 12 of the SFO

provides that the Financial Secretary may require the SFC to furnish “such information as

[the Financial Secretary] specifies on the principles, practices and policy [the SFC] is

pursuing or adopting, or proposes to pursue or adopt, in furthering any of its regulatory

objectives or performing any of its functions” (emphasis added). In the case of the HKMA,

section 9(4) of the Banking Ordinance provides that the Chief Executive of the HKSAR may

“request the Monetary Authority to report to him on any matter relating to the working of this

Ordinance or the activities of the office of the Monetary Authority, and the Monetary

Authority shall, forthwith, prepare and furnish a report to the Chief Executive accordingly”

(emphasis added).

As discussed above, existing codes of business conduct which apply to both licensed

corporations and RIs, if properly adhered to by intermediaries, would have likely preempted a

large number of the Minibond complaints now being brought to the attention of the SFC and

the HKMA. Both the SFC and the HKMA already have powers to supervise and investigate

businesses they regulate and to apply sanctions where an intermediary engages in

unacceptable business practices. Moreover, these specifics reflect core functions of both

regulatory bodies as specified in the relevant governing Ordinances. Section 5(1) of the SFO

provides that it is the SFC’s function, inter alia, (1) to promote, encourage and enforce the

proper conduct, competence and integrity of persons carrying on activities regulated by the

SFC; (2) to encourage the provision of sound, balanced and informed advice regarding

transactions or activities related to financial products; (3) to secure an appropriate degree of

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protection for members of the public investing in or holding financial products, having regard

to their degree of understanding and expertise in respect of investing in or holding financial

products; and (4) to suppress illegal, dishonourable and improper practices in the securities

and futures industry. Section 7 of the Banking Ordinance contains a considerably briefer

statement reflecting similar ideals. However, neither report raises any substantial question as

to the internal operations or activities, policies and practices of either regulator in carrying

out their regulatory mandate. 249 In the context of the current examination of Hong Kong’s

regulatory structure, the question as to whether such a review ought to be engaged in seems

highly appropriate. Such a review, if undertaken, may need to be conducted independently of

the regulators themselves and would seek to establish how the SFC and HKMA have

executed their existing powers within the current regulatory regime to fulfil their statutory

functions, and in what ways their operations, activities, policies and practices could be

improved for future benefit.

4.4 Addressing Other Existing Weaknesses

Other existing weaknesses include issues respecting financial stability, implementation of

international standards and addressing credit ratings and credit rating agencies.

4.4.1 Financial stability

Financial sector instability of the kind widely experienced since 2008­08 has been termed by

two scholars of crises as an “equal opportunity menace”, 250 in that the fallout from banking

crises is generally long­lasting in terms of lost or foregone output and employment and

worsened public finances. In emerging markets, banking crises seem also to be associated

with cyclical changes in property prices. Hong Kong is exposed to all these conditions. It is

less clear how policy or personal actions within Hong Kong have worsened the performance

of the territory’s financial system in the present period of general instability.

Some features of the banking market appear benign, but may be associated with second order

instability. In particular, aggregate loan­deposit ratios of Hong Kong banks are traditionally

249 An analysis of such issues was not requested in the context of the SFC and HKMA reports on Lehman Brothers Minibonds. 250 C. Reinhart & K. Rogoff, “Banking Crises: An Equal Opportunity Menace”, NBER Working Paper No. w14587 (National Bureau of Economic Research, Dec. 2008).

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low by comparison with other advanced banking markets, 251 but with loans among locally

incorporated banks generally less leveraged to deposits than among foreign­controlled banks.

This pattern has historically allowed a simple route for wholesale lending by non­Hong Kong

banks to be funded in the interbank markets, but in the approach to the crisis may have

allowed certain local banks to use free liquidity to acquire CDOs and other structured

assets. 252 This feature may suggest that supervision of liquidity is as important is as important

when leverage and use of funds by banks is moderate, as much as in more extreme cases.

Hong Kong shares with Singapore an experience of the crisis that is to date unusual, in that

there has been no general systemic instability or loss of confidence and no need for state

funds for bank recapitalisation, but that consumers have appeared to suffer losses in a

material way, with Lehman Brothers Minibond holders facing losses similar to shareholders

of large organisations such as AIG, Citigroup, Northern Rock and Royal Bank of Scotland. In

this respect, Hong Kong’s experience to date has been more similar to those of Australia,

Canada and Spain (whose financial regulatory systems are now being viewed as models) and

less similar to those of the United States or the United Kingdom. Plainly, regulation of

complex transactions has been deficient in Hong Kong, and supervision at the point of sale

weak, in effect leading to a lack of transaction transparency and increasing the risks of

misselling. At the same time however while Hong Kong may be considered lucky in the

context of not having to face the failure of AIG thanks to the intervention of the US

government, it has certainly experienced very little in the way of direct exposure to the

primary systemic financial problems which have emerged. In this, it largely has the actions of

the HKMA to thank for not allowing the development of a significant shadow banking

system – a characteristic shared with Canada, Spain and Australia.

In looking at these features, while Hong Kong has generally dealt appropriately with financial

stability issues and external reviews have generally been favourable of its approach, in light

of international experience with the financial crisis, there is a strong argument that the

HKMA, like other central banks around the world, should receive an explicit legislative

251 HKMA data show that the Hong Kong banking sector’s aggregate local currency loan­deposit ratio was 77.6 per cent at end­2008, and in all currencies 54.2 per cent. Both ratios have been in a downward cyclical trend since at least early 2000. 252 For example, BEA reported a 97.5 per cent fall in 2008 annual net income to HK$104 million (US$13.3 million) due mainly to CDO losses of HK$3,549 million (US$455 million), rumours of which had been the root of popular concerns during 2008, see s. 3.2 above.

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financial stability mandate and that the existing FSC mechanism should receive a greater

level of attention and formalisation.

In looking at other existing weaknesses, at the first level are areas of specific concern in

Hong Kong raised by the crisis, namely deposit insurance, insurance consumer compensation

arrangements and mechanisms for dealing with failed financial groups. In relation to deposit

insurance, the crisis (through the run on BEA) has highlighted that Hong Kong’s existing

(and relatively new) HK$100,000 limit is insufficient. 253 The trend internationally appears to

be towards much more comprehensive coverage, with something in the neighbourhood of

HK$400,000 probably being more appropriate. 254

Second, the IMF in 2003 noted Hong Kong’s lack of a similar compensation mechanism in

the context of insurance. The near failure of AIG and consequent panic has highlighted the

urgency of developing such a scheme, consistent with the deposit protection scheme and the

securities investor compensation arrangements. A possible arrangement would be a merger of

the existing DPS for banks and the Investor Compensation Scheme (ICS) for securities,

combined with the addition of a mechanism to deal with insurance. In such a way,

arrangements could be both centralised and consistent, including in the context of the failure

of a financial conglomerate. 255

Third, while Hong Kong has in place an effective mechanism for addressing problem banks,

the failure of Lehman Brothers (and the near failure of AIG) has highlighted the need for a

comprehensive and consistent scheme for resolution of failing financial groups as well as a

broader scheme to address corporate restructuring. Such a system would probably make the

most sense as part of a process of overall regulatory restructuring – discussed further in the

final section.

At the same time, as noted above, despite widespread criticism, the implementation of the

dual filing regime appears to be an effective mechanism to deal with the division of

responsibilities relating to listing and listed companies between HKEx and the SFC. The

253 As noted above, the Carse Report, supra note 95, p. 51, recommends the need for a review of the system. 254 For discussion of deposit insurance, see R. Lastra & D. Arner, “Comparative Aspects of Depositor Protection Schemes”, in Arner & Lin, supra note 5. 255 A similar structure has been adopted in the United Kingdom under the Financial Services and Markets Act 2000. At the same time however Hong Kong’s DPS does not suffer from the same delayed payout and shared losses systems which made the UK system particularly problematic in the context of Northern Rock.

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effectiveness highlights the value in strengthening this system, with HKEx focusing on listing

and the SFC dealing with enforcement. Nonetheless, this system should be strengthened

through implementation of the current proposals to amend the SMLR to extend its scope.

4.4.2 Implementation of international standards

Hong Kong will also need to address the range of international regulatory changes being

made in response to the global credit crisis. 256 Whilst Hong Kong has played a significant

role in the development of international financial standards (such as through its membership

in the FSF), it will also be important to increase this participation – after all, despite the

Lehman Brothers Minibond and other problems, its financial regulatory system has

performed better than most, partly perhaps as a legacy of experiences from past banking

problems. 257 Furthermore, in relation to implementation of standards, as noted, many

jurisdictions are likely to follow a reactionary approach as a result of the crisis. If Hong Kong

is able to implement international standards without stifling financial development and

innovation unnecessarily, this may provide an important competitive advantage: the

incidence of fewer problems in Hong Kong suggests that the regulatory response here can be

less draconian than the approaches likely to be taken in London and New York. The emphasis

of any regulatory reform should thus be on more effective regulation, not necessarily more

regulation.

4.4.3 The role of credit ratings and credit rating agencies

The recent findings of a report from the Committee on the Global Financial System of the

Bank for International Settlements 258 are of relevance in this context: (1) the key role played

by credit rating agencies CRAs as “delegated monitors” in the structured finance market; (2)

they not only provided credit assessments but were also involved in the design and the

structuring, contributing to development of standards; (3) large institutional investors did not

rely solely on ratings; and (4) CRAs’ conflict of interest in certain circumstances.

256 The Carse Report also makes this recommendation, see supra note 95, pp. 1 & 10. 257 See L. Goodstadt, Profits, Politics and Panics – Hong Kong’s Banks and the Making of a Miracle Economy, 1935­1985 (HKU Press 2008). 258 Committee on the Global Financial System, The role of ratings in structured finance: issues and implications (Bank for International Settlements, Jan. 2005).

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During the course of the current crisis, the failings of the CRAs and their rating

methodologies were shown in sharp relief, first revealed following the Asian Financial Crisis

(1997) and emphasised again in the context of the failures of Enron (2001) and Worldcom

(2002), and have thus been seriously discredited in the context of structured financial

products. Moreover, the agencies have been thoroughly chastised for conflict of interest in

their involvement in the advising, designing and the structuring of structured instruments and

their being remunerated by the very parties whose instruments were being rated. Regulatory

authorities around the world are calling for and taking action, putting into place tighter

governing legislation and rules, with the European Commission currently the most vocal

force at present. A compromise discussed in late 2008 and favoured by both European and

US authorities may be based on a separation of rating agency activity into coverage of

traditional transactions, which would be left largely unchanged, but new and more stringent

rules in respect of structured finance, where the agency conflicts are most apparent. At the

same time, the FSF has agreed to undertake a full review of the usage of credit ratings within

the regulatory system, with a view to shifting responsibility amongst regulators and investors

on such ratings to direct responsibility for investment and regulatory decision­making.

As in other jurisdictions, the use of credit ratings in Hong Kong is statutorily required to

assist market participants to select securities for investment purposes, 259 to identify which

entities or debt are eligible, 260 to assess the value of rated securities, 261 and to assist in the

calculation of the capital adequacy ratio of banking institutions. 262 Hong Kong imposes a

regulatory regime on CRAs by way of recognition or approval. However, the authority to

recognize or approve CRAs is scattered across different government agencies under various

ordinances. The SFC and the MPFA are responsible for approving CRAs under the Securities

and Futures (Financial Resources) Rules 263 and the Mandatory Provident Fund Schemes

Ordinance respectively. 264 The Secretary for Financial Services and the Treasury is

empowered to recognize CRAs under the Trustee Ordinance. 265 The HKMA has a more

259 See, e.g., Mandatory Provident Fund Schemes (General) Reg. (Cap. 485A), s. 37(2); Securities & Futures (Insurance) Rules (Cap. 571AI), ss. 4 & 5; Trustee Ord. (Cap. 29), sch. 2. 260 See, e.g., Mandatory Provident Fund Schemes (General) Reg., ss. 68 & 71; section 14A, Inland Revenue Ordinance; Securities and Futures (Financial Resources) Rules (Cap. 471N), s. 58 (“Financial Resources Rules”). 261 Insurance Companies (General Business) (Valuation) Reg. (Cap. 41G), s. 4. 262 See, e.g., Banking (Capital) Rules (Cap. 155L) (“Capital Rules”). 263 Financial Resources Rules, s. 58. 264 Mandatory Provident Fund Schemes (General) Reg., s. 2. 265 Trustee Ord., sch. 2.

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important role: both the Inland Revenue Ordinance (Cap. 112) and the Banking (Capital)

Rules provide that only CRAs recognised by the HKMA may assign credit ratings in

compliance to their statutory provisions. 266 The main international CRAs, e.g. Moody’s,

Standard and Poor’s, and Fitch, are given recognition or approval under relevant rules and

regulations, such as the Banking Ordinance, while others are not. Although there are a

number of statutory provisions in Hong Kong requiring credit rating, “credit rating” has not

been statutorily defined. The same is true for its criteria of recognition or approval, although

at least the HKMA has published guidelines for recognition criteria in 2007, 267 which are

more detailed than the provisions of Basel II. The gaps and inconsistencies in the current

framework suggest that the regulatory framework for CRAs in Hong Kong should and must

be harmonised and rationalised.

Risk assessment and management are always the responsibility of financial institutions and

investors. As the regulator of banking industry, under the internal ratings based approach of

Basel II, the HKMA is required to supervise the internal rating procedure adopted by the

banking institutions. 268 In respect to the use of credit ratings for prudential regulatory

purposes, the HKMA should be the dominant regulatory authority. At the same time, in the

context of regulation of the use of credit ratings for other purposes, in cases relating to

investment management, such regulation must be with the market conduct regulator –

preferably a single market conduct regulator as discussed in Section 5 below. Assuming that

the role of ratings will be reduced and the responsibility of investors for investment decisions

will be increased, as market information and research services providers, regulation of rating

agencies generally (including authorisation and ongoing compliance) would logically also fall

with the market conduct regulator.

In addition, the transparency, independence, on­going review, and liability of the CRAs in

Hong Kong need to be addressed. In the United States, courts have held that reliance on

credit ratings is unreasonable, given the express disclaimers, and that credit ratings are

protected by Constitutional provisions addressing freedom of speech. 269 While there is no

precedent in Hong Kong, Article 26 of the Basic Law provides that Hong Kong residents

266 Inland Revenue Ord., s. 14A; Banking Ord., s. 4; Capital Rules. 267 See HKMA, Supervisory Policy Manual: Supervisory Review Process, CA­G­5, Annex A; idem., Recognition of External Credit Assessment Institutions. 268 Id. 269 Quinn v. McGraw­Hill, 168 F. 3d 331 (7 th Cir. 1999).

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shall have freedom of speech, of the press and of publication and Article 30 of the Basic Law

guarantees freedom of communication. The extent of these constitutional provisions and the

Control of Exemption of Clauses Ordinance (Cap. 71) in affecting the liabilities of CRAs in

Hong Kong warrant further investigation.

Having discussed current problems and existing weaknesses, it is now appropriate to look

forward and to consider how the crisis may be turned into an opportunity to support Hong

Kong’s position as an international financial centre.

5. Looking Forward: Enhancing Hong Kong’s Competitiveness

Hong Kong is the only developed jurisdiction that is legally required to maintain its status as

an international financial centre. 270 In this context, it continues to rank highly in surveys of

the perceived competitiveness of international financial centres, and according to a widely­

circulated commercial survey commissioned by the City of London, Hong Kong has

consistently ranked as the third or fourth most competitive international financial centre,

behind London, New York and (in the most recent survey) Singapore. 271 At the same time, as

highlighted by the preceding discussion and as recently initiated by the Financial Secretary,

Hong Kong needs to undertake a comprehensive analysis of the competitiveness and efficacy

of its financial regulatory system with the express objective of improving its attractiveness

and effectiveness as a financial centre.

5.1 Financial Centre Competition and Competitiveness

The main factors which influence financial centre competitiveness could be summarised as

comprising governance, sophistication, liberalisation, participation, human capital,

information technology, and hinterland. While some of these factors are more amenable to

government support than others, all are areas in which governments can act to enhance

competitiveness.

270 Basic Law, Art. 109 states that the “Government […] shall provide an appropriate economic and legal environment for the maintenance of the status of Hong Kong as an international financial centre”. 271 See Z/Yen, The Global Financial Centres Index, available in summary at www.cityoflondon.gov.uk/economicresearch. The empirical basis of this and similar surveys is suspect but the results often used by the commissioning centre for promotional purposes. Similar studies have been commissioned by civic leaders in New York, Tokyo and in aspirational centres elsewhere.

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For major financial centres, the quality and incidence of governance, including legal and

regulatory issues, appear intuitively to be associated with international competitiveness,

whether measured by the volume of banking or market­based transactions, or the numbers of

intermediaries that choose to locate in a centre from time­to­time. No comprehensive

empirical analysis exists to show the extent to which legal or regulatory incentives may

attract financial activity to any centre, or cause firms to relocate their operations in any single

city, but there is anecdotal evidence that legal and regulatory factors have been responsible

for certain shifts in activity from one centre to another, and that foreign confidence in its

regulatory setting has a positive impact on competitiveness.

In addition, a number of studies concentrating on specific aspects of regulation, the cost of

compliance or on the attractions within any single centre of certain financial market

segments, have shown that law and regulation can influence cross­border capital flows, the

choice of listing locations, and to some extent the reasons for intermediaries to establish a

local presence in preference to a close alternative. For example, the costs associated with a

foreign company obtaining and maintaining a US stock market listing have risen since the

enactment of demanding post­Enron legislation, 272 but for those companies persisting in

carrying those costs, prevailing listing and trading price­earnings multiples have been

comparatively favourable. US regulation posts a high barrier to foreign listing candidates but

those passing the hurdle are welcomed by US investors. Other studies have shown that the

relative perception of quality in regulatory design and enforcement has a positive impact on

cross­border capital flows, including foreign direct investment. 273 The disposition of banking

activity may be less well­attuned to these comparative factors. Thus intense financial

regulation or supervision may be generally associated with qualities and resources that are

attractive to foreign users, but will begin to repel activity at a certain level or cost. In each

case, the decision to locate, list, invest or lend in a specific jurisdiction will be subject to

economic and other influences. Hong Kong would be wrong to believe that an under­

regulated, libertarian approach of the kind associated with the territory’s banking markets

until the late­1980s would engender financial activity, and the collapse in general confidence

since 2007 would appear to enhance the value of a regulatory regime that is seen as effective

272 Sarbanes­Oxley Act of 2002, 15 USCS §§ 7201 et. seq. One prominent group of US academic and financial industry interests argues as a result, that US law and regulation have blighted the competitiveness of its financial sector, see Committee on Capital Markets Regulation, Interim Report (Nov. 2006). 273 See, e.g., H. Jackson & M. Roe, “Public Enforcement of Securities Laws: Resource­Based Evidence”, Journal of Financial Economics, (forthcoming 2009).

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and well­enforced. High costs may deter activity but regulatory quality and intensity in

enforcement seems to support market development and competitiveness.

Governance factors are essential not only to competitiveness but also sophistication,

liberalisation and participation. Sophistication issues result from actions or inactions to

encourage financialisation, an objective that the subprime crisis has highlighted may be

inappropriate or undesirable for any single economy. Sophistication thus also relates to issues

of liberalisation: a fully liberalised financial system, open to global competition is probably

essential for an international financial centre (though by not to a similar extent for a domestic

financial centre). As such, domestic economic objectives may conflict with the emergence of

a domestic international financial centre in certain economies. Participation in turn relates to

liberalisation, at least to the extent that one is concerned with global participation as opposed

to merely domestic participation. In addition however financial sector development even at

the purely domestic level is based on increasing domestic savings and investments, through

enhanced participation in the formal economy and financial system. Once again, governance

factors (especially in relation to the first level institutional underpinnings) play a key role

here.

There is also a clear relationship between the economic/financial hinterland of any given

financial centre and legal and governance strategies. For instance, economic area can be

increased through the formation of national, regional and international economic zones. In

this respect, the development of the European Union and especially its integrated market for

wholesale finance highlight the potential that may exist in other regions, with specific

examples currently in ASEAN and the Gulf Cooperation Council (GCC). 274

The remaining two factors (technology and human capital) are perhaps of less interest from a

purely legal standpoint but are of high interest from an academic standpoint as well as that of

governments. As noted above, human capital may be the key factor in financial centre

competitiveness, or at least one of the two key factors along with governance. (Further,

technology in many ways will come with competitiveness in governance and human capital.)

Human capital development requires extensive government commitment to developing

domestic resources through well­designed education and healthcare systems (which in turn

274 For discussion in the context of East Asia, see D. Arner, P. Lejot & W. Wang, “Financial Integration in East Asia”, Singapore Yearbook of International Law (forthcoming 2009).

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depends largely on an effective fiscal regime – one of the fundamental underpinnings of a

developed economy and financial system 275 ) at the domestic level. At the same time,

financial centre competitiveness requires more than successful domestic human capital

development, it also requires openness to human capital from outside the jurisdiction – as the

markets are global, the players are global and the competition for the best people is also

global. In this way, once again, developing a competitive international financial centre may

not necessarily coincide with other domestic economic, political and social objectives.

In looking forward, one can identify the parameters of the competition of financial centres – a

competition in which law and regulation play a central role. At the same time, developing a

competitive international financial centre (as opposed to an effective domestic financial

centre) may conflict with other objectives of a given country / society / economy, even in

terms of competitiveness (for instance, it may be to a given country’s advantage to restrict

certain aspects of the liberalisation requisite for a successful international financial centre in

the interests of the development of the country’s economy as a whole). As such, there are

both benefits and costs to the competition for global financial centres.

5.2 Opportunities

One area in which the crisis provides an opportunity for enhancing competitiveness lies in

international responses to issues relating to counterparty risk with of OTC derivatives.

Specifically, it may be valuable for the HKMA and HKEx to become associated with official

or private sector efforts, respectively, now under way in the United States and Europe to

sponsor or give regulatory authorisation to central organisations for the clearing and reporting

of CDS contracts and their associated collateral. Transparency in CDS pricing and

contracting has become a widespread political demand since the fall of AIG, mainly to allow

both global markets and their regulators a clear insight at any time as to the general

disposition of credit risk among banks and other intermediaries. At present, information on

almost all completed global CDS trades (other than those wholly embedded in other

transactions) is collated by the Trade Information Warehouse facility of US­based Depositary

Trust and Clearing Corporation (DTCC) but published only weekly and in aggregate form.

275 See Arner, supra note 75.

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If the system is further developed with transnational regulatory sanction, either under DTCC

or a US or EU clearing competitor, then a single bridging facility from East Asia could be of

value to users, other counterparties and regulators. The volume of CDS contracts sold by

Asian counterparties is comparatively small so that a new and separate local organisation

may seem to be of little value, but as the market develops, it may be significant to have an

Asian clearing and settlement mechanism both to support development of a generally useful

market while at the same time supporting financial stability (the key weaknesses which have

emerged in the market in the context of the global financial crisis are counterparty risk and

transparency – risks that can be directly addressed through central counterparty and reporting

arrangements). This is especially the case given that a consensus has recently emerged among

US and EU regulators of the lack of value to an enforced migration of OTC CDS trading to a

central setting involving a single exchange counterparty for all contracts: the likely result is

now at least one or more counterparty arrangements in both the United States and the

European Union. As such, a natural addition would be one or more arrangements in Asia.

Finally, Hong Kong’s competitive future largely depends on increasing its role as China’s

global financial centre, especially in the context of yuan denominated transactions, a locus for

cross­border fund management, and a supplier of transaction resources to Mainland users. In

this respect, Hong Kong has done well so far in receiving support from the central

government; related initiatives therefore need to continue. In the long­run, Hong Kong’s

financial sector prosperity may depend upon the extent to which it maintains its entrepôt

attractions as China’s barriers to cross­border transactions are steadily removed.

5.3 Reforming Regulatory Structure

One issue bears specific mention: the overarching design and structure of the financial

regulatory system. In the context of the financial stability issues which arose during the crisis,

given that many issues arose from regulatory gaps and balkanisation, the first step is to

consider the system in a broad and integrated way.

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5.3.1 Options

Overall, a number of lessons have emerged. 276 First, countries must examine carefully the

advantages and disadvantages of any possible change, including the risks inherent in the

change process itself. Second, a number of basic models or structures are possible including

the traditional sectoral model (with separate regulators for each financial sector, namely

banking, securities and insurance, often combined with strict separation or holding company

structures for financial conglomerates); the functional model (with separate regulators for

each regulatory function – for example, financial stability, prudential, market conduct and

competition regulation – catering to financial conglomerates and product innovation); and the

integrated structure (with one or more sectors and/or functions combined in a single agency,

often combined with a universal banking model for financial services provision). It cannot be

taken for granted that a model is, per se, better than any other; it depends very much on the

particular circumstances of the jurisdiction concerned. The third key lesson is that there is an

important relationship among regulatory structure (and attendant financial and human

resources), financial structure (the relative importance of banking, insurance and capital

markets and the level of financial development or repression) and the structure of financial

institutions (e.g., strict separation of financial sectors versus universal banking).

With this in mind, the second clear conclusion is that regulatory structure must be designed to

coincide with an economy’s financial structure. 277 There must be full coverage of the

intermediaries (especially financial conglomerates), functions and risks inherent in a given

financial system and done in a manner that coincides with the history, culture and legal

system of that economy. An additional risk involves financial structure and regulatory design

(“financial and regulatory mismatch”). In this respect, the risk is that a jurisdiction’s financial

regulatory structure will not equate with the structure of its financial sector, that is, financial

intermediaries will be organised on a basis which is not appropriately addressed by the

regulatory structure. In such circumstances, it is possible that significant risks may develop

through financial intermediary operations which are not supervised by the existing structure.

For example, in a strict separation financial system, informal financial groups may develop,

which in turn are not regulated on a group basis, but only on a sectoral institutional basis,

276 For a detailed discussion, see Arner & Lin, supra note 5. 277 For a full discussion of financial structure, see Arner, supra note 75.

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leaving the financial system exposed to the risks of the “group”. It is exactly these sorts of

risk which have been highlighted in Hong Kong by the global financial crisis.

As noted above, as a general matter, there are a number of major structural models which

have been adopted by jurisdictions around the world: (1) integrated or single regulator; (2)

sectoral regulation; (3) functional regulation; or (4) institutional regulation. 278

Under the integrated or single regulator structure, a country has a single financial regulator

responsible for all aspects of the financial system and financial supervision. This model has

been adopted in the United Kingdom (Financial Services Agency or FSA), Japan (Financial

Supervisory Agency or FSA) and Singapore (Monetary Authority of Singapore or MAS). 279

This model works well with universal banking but can also work with other structures of

financial intermediary activities and financial conglomerates.

Under the sectoral regulation model, a country has separate regulators for each financial

sector (typically, banking, securities and insurance). This model has been adopted in the

majority of countries around the world, including the United States and China. 280 This model

278 For a detailed discussion of major models and their implementation in various jurisdictions, see Arner & Lin, supra note 5. This analytical division is generally used outside the United States and by the IMF. For an alternative framework of analysis (adopted in the United States), see Group of 30, The Structure of Financial Supervision: Approaches and Challenges in a Global Marketplace (Group of 30, Oct. 2008). Under the G30 / US framework, there are also four models: (1) functional; (2) institutional; (3) twin peaks; and (4) integrated. Under this framework, the “functional” model is largely equivalent to the more generally used “sectoral” model. The “functional” model is largely equivalent to the more generally used “institutional” model. The “integrated” and “twin peaks” model (discussed further below) are equivalent in both the US/G30 and international/IMF formulations. The G30/US framework does not have an equivalent to the international / IMF “functional” approach. To further complicate matters, in its recent review of regulatory reform options, the US Treasury suggested there are four main options: (1) institutionally based functional regulation (the current US model); (2) activities based functional regulation (a model based on regulators assigned specific functions within the financial system); (3) consolidated regulation (the model in the United Kingdom); and (4) objectives based regulation (the model in Australia). US Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure (Mar. 2008) (“US Treasury Blueprint”), pp. 138­42. As a result, terminology and understanding the definition of that terminology being used in of significant importance in this context. 279 In the United Kingdom and Japan, the FSA is a separate agency from the central bank (Bank of England and Bank of Japan, respectively). In this structure, the central bank is responsible for monetary policy and financial stability, while the FSA is responsible for financial regulation. The United Kingdom has also adopted a single statutory framework for the FSA and financial regulation, the Financial Services and Markets Act 2000. In Japan, there are separate statutes dealing with individual financial sectors (banking, securities, insurance etc) but administered by the FSA. In Singapore, the MAS combines the roles of central bank and financial regulation. The statutory framework in Singapore comprises individual laws for each major sector, administered by the MAS. 280 China has the clearest example: People’s Bank of China (central bank), China Banking Regulatory Commission (CBRC, responsible for banking regulation), China Securities Regulatory Commission (CSRC, responsible for securities regulation) and the China Insurance Regulatory Commission (CIRC, responsible for insurance regulation). In the Mainland, each regulator is established under and responsible for a separate

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works best with a system of strict sectoral separation of financial intermediary activities. It is

also often used in countries which have adopted the financial holding company model or the

parent / subsidiary model. It does not work well with universal banking models. The recent

experience of the United States also highlights that it may not be ideal in the context of

financial holding company models as well.

Under the functional regulation model, a country has separate regulators responsible for

major regulatory functions. The purest example requires separate regulators responsible for:

(1) financial stability regulation; (2) prudential regulation of financial intermediary safety and

soundness; (3) financial market conduct; and (4) competition. This model has been adopted in

Australia, one of the developed common law countries which has not experienced serious

financial sector problems in the current crisis to date. 281 Today, financial stability regulation

and prudential regulation are often combined in a single agency, with a separate agency

responsible for financial market conduct (the “twin peaks” approach). 282 This model has been

adopted in the Netherlands and France and is currently being considered in the United States

as a result of the subprime crisis. 283 This model can work with any model of financial

intermediary activities and financial conglomerate structure.

Under the institutional regulation model, all activities of a given type of financial

intermediary are regulated by one regulator, regardless of the specific type of activity being

undertaken. As a general model, this has not been adopted in any system; however, it is

frequently adopted in the context of banking regulation around the world. In the most

common structure resulting from the special systemic risks posed by banks and banking, all

activities of banks, whether financial or non­financial, whether cross­sectoral or not, are

regulated by the banking regulator (usually the central bank), with the balance of regulatory

responsibility allocated on a sectoral basis. This is the traditional structure which has

statutory framework, with cross­sectoral activities generally prohibited, though increasingly being allowed especially between banks and securities activities. For fuller discussion, see J. Barth, Z. Zhou, D. Arner, B. Hsu & W. Wang (eds), Financial Restructuring and Reform in Post­WTO China (Kluwer 2006). The US regulatory system is exceptionally complex and this complexity and resulting overlaps and gaps in jurisdiction are now regarded as significant in the subprime crisis. See US Treasury Blueprint, supra note 278. 281 In Australia, the Reserve Bank of Australia (RBA) as the central bank is responsible for monetary policy and financial stability, the Australian Prudential Regulatory Agency (APRA) is responsible for regulating the safety and soundness of all significant financial institutions, the Australian Securities and Investments Commission is responsible for market conduct and financial product regulation, and the Australian Competition Commission is responsible for competition / antitrust. 282 See M. Taylor, Twin Peaks: A Regulatory Structure for the New Century (Centre for Financial Innovation 1995). 283 See US Treasury Blueprint, supra note 278.

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developed in many jurisdictions, including Hong Kong. In most cases, this will be extended

to the context of any company owning a bank, so for instance, if an insurance company owns

a bank, then the banking regulator would then regulate all activities of the insurance company

as well.

Once again, there is no general consensus as this time which model is best. The fundamental

issue is tailoring a country’s financial regulatory structure to its own circumstances and

especially its structure for addressing financial intermediary activities and financial

conglomerates. This is a discussion the time for which has come in Hong Kong.

5.3.2 Recommendations

Against this background, reform of the existing system in Hong Kong, developed largely

through trial and error and resulting in a confusing matrix of sectoral laws and agencies with

many gaps and inconsistencies, should result in a more coherent system based upon specific

objectives and well­defined roles – in other words, a more functional than traditional sectoral

/ institutional framework. To some extent, such a system would be similar to that which has

been adopted in Australia, the Netherlands and France, and presently being considered in the

United States. While amalgamation of regulation into a single regulator may at first instance

appear attractive in a small jurisdiction such as Hong Kong, it also would have certain

disadvantages. Specifically, Hong Kong has two highly regarded regulatory bodies (the

HKMA and the SFC) which have generally been very effective in performing their primary

mandates (monetary and financial stability, and investor protection, respectively). Any

merger of these two well­established organisations would be problematic, in that in all

likelihood, one would dominate (with a consequent reduction in other functions which would

then be regarded as less important than the dominant organisation’s previous primary role) or

the integration would not succeed (with the two major preexisting agencies working in

parallel albeit under the aegis of a single umbrella).

As a result, in the context of the specific circumstances of Hong Kong, a “twin peaks”

structure which builds upon existing regulatory strengths while addressing existing

weaknesses would seem preferable. Such an approach would bring together like

responsibilities into two main regulatory bodies, one generally responsible for monetary and

financial stability and prudential regulation across the financial sector and across financial

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institutions and the other responsible for consumer protection, market conduct and

enforcement activities. The two would in turn be supported by a separate board responsible

for compensation arrangements.

Under this proposal, the HKMA (under a revised statutory framework) would be responsible

for monetary stability, financial stability (under an explicit mandate) and prudential

regulation and supervision of all financial institutions, including banks, insurance companies

and securities firms. To be clear, prudential regulation here specifically refers to the

supervision of a firm’s capital, liquidity and leverage as part of the means of controlling

systemic risks. Thus, the HKMA would, in addition to its existing monetary responsibilities,

become the primary regulator of the safety and soundness of financial institutions of all sorts

in Hong Kong, thus addressing prudential concerns regarding financial conglomerates and

other gaps. At the same time, the HKMA’s existing powers of intervention and management

of problem financial institutions would be extended beyond banks to cover any systemically

significant financial institution, with deposit / investor / insurance consumer compensation

arrangements handled via a separate agency.

As a second element, the SFC (perhaps as a renamed Financial Services Commission or FSC)

would remain responsible for securities market conduct regulation and so would continue to

be responsible for issuing and enforcing codes of business practice, although it would no

longer be responsible for prudential regulation of securities firms (as described above).

Furthermore, it would be responsible for regulating all financial products offered across all

sectors of the financial system (including banking, insurance and pensions products) and by

any financial institution or financial services provider. As a result, all financial products and

services would be regulated in a consistent manner. At the same time, there is much to be

said for having the details of the Listing Rules managed by HKEx, with its closer connection

to the financial industry, subject to enhanced enforcement powers for the SFC, a system

which also merits application to the rules of other SROs.

The OCI and MPFA would be merged into the HKMA and SFC as appropriate, with

prudential regulatory functions and personnel moving to the HKMA and market conduct

regulatory functions and personnel shifting to the SFC / FSC. As noted above, SROs would

continue to be responsible developing their various industry rules (HKAB Code of Banking

Practice, HKEx Listing, Trading and Clearing Rules, and HKFI Code of Conduct for

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Insurers). However, such SRO rules would be subject to regulatory approval and supported

by regulatory enforcement authority through statutory backing, along the lines of a

strengthened version of the dual filing system or the UK proposals for statutory backing of

the Banking Code.

In addition, the HKDPB and the ICC would be merged, in order to ensure equivalent

treatment of consumers in the context of financial institution failure, with compensation

extended on equivalent terms beyond banking and securities to insurance as well. In this

structure, the system would largely run along DPS / ICS lines and thus would require a

relatively simple organisational structure.

This reform would not only address financial stability concerns but also issues of regulatory

competitiveness. In relation to stability concerns, the majority stem from gaps and

inconsistencies which result from the existing system; these would be addressed by a more

coherent functional structure with clearly defined roles and responsibilities. In relation to

competitiveness concerns, the proposal would address the major concerns, namely the

complexity and expense of dealing with Hong Kong’s existing regulatory framework.

Overall, such reform would therefore enhance both financial stability and competitiveness

from the standpoint of compliance costs. At the same time, this would be a major change and

in all likelihood would not appeal to the various regulatory agencies (who are comfortable

with their current roles, despite stability and competitiveness issues), local business interests

(which often prefer the complexity and opportunities for regulatory arbitrage and advantage it

presents) or the Government (which may have a difficult task in managing the process).

However, most consumers (whether individuals or non­local companies and financial firms)

would prefer a simpler, clearer, more effective framework. Despite the likely objections to

such a change in the status quo, such a development in the regulatory architecture of Hong

Kong would bring about meaningful benefits to consumers, issuers and intermediaries alike,

as well as enhancing Hong Kong’s continued international standing as a financial centre.